Following four years of relative stability at around $105 per barrel (bbl), oil prices have declined sharply since June 2014 and are expected to remain low for a considerable period of time. The drop in prices likely marks the end of the commodity supercycle that began in the early 2000s.
The sharp fall in oil prices since June 2014 is a significant but not unprecedented event. Over the past three decades, five other episodes of oil price declines of 30 percent or more in a seven-month period occurred, coinciding with major changes in the global economy and oil markets (Figure 1). The latest episode has some significant parallels with the price collapse in 1985-86, which followed a period of strong expansion of supply from non-OPEC countries and the eventual decision by OPEC to forgo price targeting and increase production.
According to the World Bank, the recent plunge in oil prices has been driven by a number of factors: several years of upward surprises in the production of unconventional oil; weakening global demand; a significant shift in OPEC policy; unwinding of some geopolitical risks; and an appreciation of the U.S. dollar. Although the relative importance of each factor is difficult to pin down, OPEC’s renouncement of price support and rapid expansion of oil supply from unconventional sources appear to have played a crucial role since mid-2014. Empirical estimates also indicate that supply (much more than demand) factors have accounted for the lion’s share of the latest plunge in oil prices. Although the supply capacity of relatively high-cost and flexible producers, such as the shale oil industry in the United States, will need to adjust to lower prices, most of the underlying factors point to lower oil prices persisting over the medium-term, with considerable volatility in global oil markets (World Bank, 2015).
The decline in oil prices will lead to significant real income shifts from oil exporters to oil importers, likely resulting in a net positive effect for global activity over the medium term. A supply-driven decline of 45 percent in oil prices could be associated with a 0.7-0.8 percent increase in global GDP over the medium term and a temporary decline in global inflation of around 1 percentage point in the short term.
Over the medium term, oil prices are projected to recover from their current lows, but will remain below recent peaks and witness considerable volatility for a couple of years. The pace of the recovery in prices will largely depend on the speed at which supply will adjust to weaker demand conditions. Given that OPEC, for now, appears to have relinquished to its role as swing producer, US shale oil producers, with their relatively short production cycles and low sunk costs, may see the greatest adjustments in the short term. In the longer term, adjustment will take place from both conventional and unconventional sources through cancellation of projects. While supply is likely to be curtailed, demand is expected to pick up, along with the expected recovery in global activity and in line with broader demographic trends. However, predictions on the evolution of oil markets remain highly uncertain. Commodity prices, including oil, tend to be volatile, making forecasting prone to errors. For oil, the unpredictability is further amplified by the possibility of heightened geopolitical tensions and a sudden change in expectations regarding OPEC’s policy objectives. Over the long run, physical (geological) constraints should put upward pressure on the real price of oil, although technological advances could slow the increase.
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