Explaining the drop in global oil prices

ECONOMIC WEAPON: The North Gas Company on the outskirts of Kirkuk, Iraq. ISIS has been seizing major oil fields in Syria and Iraq since April, using its income from oil to pay its combatants and buy weaponry. Saudi Arabia, the UAE and Jordan launched several air assaults on such oil fields to cripple the militants economically.


    Mar 03, 2015

    Explaining the drop in global oil prices

    THE Middle East is burning. Fighter jets from Saudi Arabia, Jordan, the United Arab Emirates (UAE) and Egypt have attacked numerous Islamic State in Iraq and Syria (ISIS) targets in Syria, Iraq and Libya, mainly in response to the sadistic killing of captured Jordanian pilot Muath Al-Kasaesbeh.

    Amid this conflict, which began in June, oil prices have dropped significantly, from the highest level of more than US$100 per barrel in 2010 to approximately US$50 this year.

    Yet Saudi Arabia, the biggest oil producer in the Organisation of Petroleum Exporting Countries (Opec), did not do anything to cut oil supply and stabilise prices.

    The outbreak of major armed conflicts in the Middle East usually results in a rise in oil prices as oil supply to the global market is disrupted, but not this time. There are three views that explain the drop in oil prices on the global market.


    First is the security explanation. ISIS emerged in 2013 from different groups that shared a temporary common interest, toppling Bashar Al-Assad in Syria. Later, it became a threat to oil-rich countries in the region as their main interest came under attack.

    This is especially since it began to adopt a strategy using oil as a "weapon" on a significant scale, attacking and seizing major oil fields in Syria and Iraq since April last year.

    ISIS uses its income from oil to pay its combatants and buy weaponry. When the oil price was at the US$100 level, ISIS sold it at US$20 per barrel on the black market.

    The conflict in the Middle East has become a hostile rivalry to control oil fields as a strategic element that will determine the outcome. Saudi Arabia, Jordan, the UAE, Iraq, Syria and Egypt are in opposition against ISIS.

    Iraq and Syria are the battleground in the confrontation against ISIS, as these territories are where ISIS intends to build a caliphate. Nonetheless, the three monarchies believe that they will be ISIS' next targets.

    Accordingly, Saudi Arabia, the UAE and Jordan launched several air assaults on territory and oil fields seized by ISIS. Defeating ISIS is a principal interest of these monarchies.

    However, to ensure this, they need to cripple ISIS economically. Among these three, only Saudi Arabia has the ability to use oil as an economic weapon against ISIS, as it is the biggest oil producer in Opec.

    When the price of oil is as low as US$50 per barrel, then ISIS will have difficulty selling it on the black market at a reasonable price.

    This would cripple ISIS economically, which would then weaken its combat ability.

    As this is a "lose-lose" game, it will be crucial for Saudi Arabia and its allies to ensure that they will still have the ability to sustain the socioeconomic impacts caused by the strategy.

    Still, this is a realistic plan to be undertaken as, at the same time, it will indirectly hurt Iran and Russia.

    Saudi Arabia and Iran are involved in a Sunni-Shi'ite rivalry, and it has become common knowledge that Russia supports Iran and its military wing in Lebanon, Hezbollah, with weaponry.


    Second is global economic conditions. The major source of global economic growth is the Triad: the United States, European Union (EU) and Asia, especially China. All of them, in different proportions, have economies which are reliant on industry fuelled by oil, making them also the major drivers of oil demand. If they experience high economic growth, the price of oil will rise, and vice versa.

    The euro-zone crisis has not been solved yet, despite weak signals of growth in the region. Greece, as the trigger of economic problems in the region, is still incapable of escaping the crisis, despite its new national leadership.

    The EU is still trapped between "easy money" and austerity approaches in its attempt to overcome the crisis.

    China, the already awakened dragon in Asia whose economy is dependent on developed countries' economic growth as the markets for its export products, has not been able to substitute the US and EU as sources of global economic growth.

    Although it still has high growth at about 7 per cent, this is lower than its performance before the outbreak of the global crisis in 2008, when it could reach a level of about 10 per cent. The slowdown in China's economy resulted in the drop in oil demand.

    The US, despite its slow recovery as indicated by the decline in its unemployment rate to approximately 6 per cent, is still experiencing slow growth as well.

    Another development that affects the demand for oil from the US is the successful commercialisation of shale gas as a source of energy. This new development has sharply cut American oil imports.


    The third explanation for the drop in oil prices is financial market conditions. The conventional wisdom that the price of goods is determined by supply and demand is only a partial realm of today's global economy.

    Now, the price of goods is also affected by the selling and buying of financial goods (stocks, bonds, money, commodities) purchased in the capital markets.

    This has become an influential factor as there is much more money circulated in the capital market than in the market where goods and services are offered.

    In this new, unbalanced hybrid structure, the price of goods will rise if there is a massive perception that a type of financial product will give better earnings, because investors will put their money in the "product", and vice versa.

    The global financial crisis of 2008 started in the very heart of the global economy, Wall Street. To avoid mass unemployment, the US bailed out large industrial and financial companies as they were "too big to fail".

    After 2008, we witnessed the drastic rise in oil prices, from about US$60 per barrel to more than US$100 in 2009.

    This was not caused by a steep increase in oil demand, but rather because money that had been invested in the US capital market found a better place of investment in financial products related to oil.

    This was also what has happened since June, only with the opposite effect, resulting in the drop in oil prices.

    Investors were nervous because several major oil fields had been controlled by ISIS, making investment in that sector risky. This functions as a push factor.

    Meanwhile, there have been attractive pull factors in the US. The recovery of the US economy is an important factor, although it has happened slowly.

    Another important factor is the introduction of a series of quantitative easing (QE) policies, which make bonds and stocks in the US more attractive, and statements from the US Federal Reserve that it will raise its interest rate.

    This altogether has caused a strong inflow of capital to the US dollar, among others that used to be invested in financial products related to oil.

    This causes the weakening of demand for financial products related to oil, again putting pressure on the price of oil.

    As the radical drop in oil prices that started in June is shaped by a set of complex reasons, it is unlikely that it will bounce back soon.


    The writer is a lecturer at the Catholic University of Parahyangan, Bandung, and a member of the Parahyangan Centre for International Studies.