Will Oil Drop to $40?

The reason it fell is that no one wanted it. The global economy was at a standstill and people were keeping both hands on their wallets and not buying anything that was not absolutely necessary.

This time is different. The story is that supply primarily due to booming production in the United States is outstripping demand and the invisible hand is doing its work. The world is awash in oil, the thinking goes, and until supply and demand return to rough balance, prices will stay low and may go even lower.

Could oil drop to $40 a barrel again? If the Saudis and OPEC follow through on their current policy to fight for market share, there is every chance that prices could fall that far.

Could oil prices remain at around $40 a barrel for a long time? Probably not, and that is what makes this time different.

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The last time the Saudis decided to fight for market share rather than cutting production to raise prices was in the early 1980s, when crude prices fell to around $12 a barrel (about $31 in 2014 dollars). However, the drop was expansionary for the economy. The money that countries and consumers saved on oil and gasoline was spent on other goods.

This time the drop in crude prices could easily be contractionary. As the crude price falls, the incentive wanes for companies to invest in finding more oil, and unless the global economy begins to grow strongly again, demand for energy will remain low.

Only 3 billion new barrels of recoverable oil and condensate were found in 2014, the lowest total in 25 years, and half the amount discovered in the previous year, according the Schlumberger Ltd.’s (NYSE: SLB) president of operations. That typically indicates there should be more exploration in the coming year, not less, but most projections for capital budgets in 2015 call for less spending, not more.

The oil companies themselves are not saying how much it costs to produce a barrel of oil in North Dakota’s Bakken shale play, but the International Energy Agency (IEA) has estimated that most drillers would make a profit at $42 a barrel. Not very much profit, though, and if profits are going to get squeezed, oil companies will spend less on exploration to make sure they are able to pay dividends and buy back stock in order to keep investors happy. Oil company executives do not want to preside over the same kind of bloodletting that has hit the precious metals, coal and iron-ore miners.

Oil at $40 a barrel is possible, even likely, but a price that low is not sustainable. Should the price drop that far, then the global economy is in bigger trouble than we think. If it stays that low for a while, the world’s economy will be in recession. Not a pretty picture.

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