FALLING oil prices are good news for consumers, but bad news for producers.
Oil prices will not stay low forever, but innovation has changed the way oil markets work.
In the short run, rising Iraq and Iran output could force prices lower and the upside is capped by the price at which US shale oil producers restart production.
In the long run, US shale producers will keep reducing costs, and horizontal drilling allows extraction of more oil from conventional fields.
So barring political unrest causing major output disruptions, oil prices should fall lower.
For decades, Saudi Arabia held up oil prices by restricting output. In recent years, it had about two million barrels a day (mbd) in spare capacity, in a world market of 95mbd.
The US shale oil boom almost doubled US output in recent years to 9.5mbd.
To keep oil price high would have meant Saudi Arabia cutting output as high-cost US output rose.
Instead, the Saudis raised output and oil prices collapsed from more than $US100 a barrel in 2014 to $US30 a barrel. Output still exceeds demand by about 2mbd and oil in storage is at record levels and rising.
The Saudis hope to force high-cost US shale oil producers to close.
They are also reluctant to cut output if it is just replaced by higher output from their religious rival, Iran, as it raises output following the lifting of trade sanctions.
Despite this week’s proposal for major oil producers to hold output constant, it seems unlikely that both Iraq and Iran will agree to do so.
In any case, to balance markets quickly would require output cuts.
US oil output has fallen more slowly than expected, but monthly output is now falling more rapidly and world demand is rising.
If Iraq and Iran output rises only gradually, the oil market could move into equilibrium by early 2017.
Oil prices would then rise to about $US60-70 a barrel where US shale oil producers can profitably increase production.
Oil prices could jump sooner.
The longer oil prices remain low the greater the chance of political problems causing output cuts in Venezuela, Nigeria, Russia, Algeria or Libya.
The Saudis have only limited spare capacity.
Higher US oil shale production would be required, unless Iraq and Iran raised output rapidly.
A lower oil price helps net oil-consuming nations such as Europe, Japan, India, China and the US.
But it hurts net oil-producing nations and oil companies.
Interest rates on loans to energy companies and oil producing nations have therefore jumped.
To fund budget deficits, oil-producer sovereign wealth funds are selling assets and asset markets have been hit.
The dynamics of the oil market have changed now the Saudis are no longer prepared to cut output to hold prices up.
Forecasting oil prices is hard given politics and economics interact.
But economics suggests oil prices will be determined by how much Iran and Iraq boost output and the cost structure of US shale oil producers.
DR ED SHANN IS AN INDEPENDENT ECONOMIST AND FORMER CHIEF ECONOMIST AT SHELL (AUSTRALIA)
‘Oil prices will not stay low forever, but innovation has changed the way oil markets work.’ Picture: Bloomberg FALLING oil prices are good news for consumers, but bad news for producers. Oil prices will not stay low forever, but innovation has changed the way oil markets work. In the…