Oil Prices: 5 Things You Need to Know Now
Business + Economy

Oil Prices: 5 Things You Need to Know Now


If you're looking for a bottom for oil prices, you might be tempted to think the recent bounce represents the end of a historic, six-month crash.

But the next move for the price of crude is anybody's guess. A lot depends on how producers and consumers react to the new bargain price.

Related: Why Oil Prices Are Headed Below $35 a Barrel

If you'd like to try come up with your own forecast, here's what you'll need to keep in mind:

Why are oil prices falling so far so fast?
Just like a hot ticket on Stubhub, the global price of oil is set by middlemen who broker sales based on supply and demand. Lately, they've got a lot of unsold product to deal with. Simply put, the world is awash in oil.

On the demand side, the growth in consumption has been slowing—for several reasons. First, much of the developed world is now seeing the payoff from investment in alternatives like natural gas and renewables. Consumption has also been dampened by widespread improvements in fuel efficiency in houses, cars, commercial buildings, airplanes, industrial equipment—you name it. Those investments in efficiency were driven by high fuel costs.

Gasoline consumption in the U.S., for example, peaked in the summer of 2007 and began falling as car buyers switched to higher-mileage cars. More recently, the growth in demand has been winding down as the global economy—with the exception of the U.S.—continues to slow down.

Related: How Plunging Oil Prices Could Create Economic Upheaval

On the supply side, meanwhile, U.S. producers have come on strong with major new supplies that no one expected. After declining for decades, U.S. producers of so called tight oil—long thought to be too expensive to produce—ramped up new technologies like horizontal drilling to boost output. Last year, the U.S. produced 14 million barrels per day, more than Saudi Arabia or Russia, according to the EIA data.

But what happened to OPEC? Doesn't it control oil prices?
OPEC's capacity to "set" global prices was always limited. Even in its heyday, the cartel had trouble agreeing on production cutbacks. But by cutting production, OPEC "swing producer" Saudi Arabia maintained a fairly effective floor on prices for many years.

But the Saudis now appear to have a different strategy for regaining control of the oil market. Saudi oil is among the cheapest to produce, so by letting prices crash, they're apparently hoping to restrict supplies by putting higher-cost producers out of business.

Is the plan working?
It may be. After holding steady, the number of U.S. oil rigs in operation began falling last month, and several major Western oil producers announced plans to cut back on drilling and exploration projects. That may be why oil prices bounced up a bit in the last few weeks.

Related: 5 Issues That Could Impact Oil Prices in 2015

So does that mean oil prices are going back to where they came from, above $100 a barrel?
For that to happen, supplies would have to tighten up quickly. In the short run, that doesn't appear to be happening, according to oil analysts at Petroleum Intelligence Weekly. Overproduction has created a large stockpile of unsold oil that will continue to weigh on prices even as some high-cost production is shut down.

"The question here is whether the market will run out of storage space before the delayed reaction from non-OPEC producers succeeds in slowing global supply," the analysts wrote in a recent report.

The analysts said the Saudis new ploy has left the global oil market in "uncharted territory." A lot depends on just how many producers cut back. Many countries that depend heavily on oil revenues, for example, may continue to produce at below cost just to keep the money flowing. The PIW analysts expect non-OPEC production will continue to grow by 1.16 million barrels per day—while demand rises by only 800,000 barrels a day. That's hardly a formula for higher prices.

That's good, right? Doesn't everybody want cheaper oil?
If you're an oil producer, not so much. For countries around the world—or U.S. states—that rely heavily on oil revenues to pay the bills and create jobs, lower crude prices are inflicting varying degrees of economic pain.

For consumers, the lower prices is like a tax cut, freeing up money for savings or spending on other goods and services. That's good for economic growth, which is one reason the U.S. economy is expected to do relatively well this year.

It remains to be seen, though, how consumers respond to the new oil price bargains. If they skip the investment in fuel efficiency—and go back to gas-guzzling trucks and SUVs, for example—that demand side of the equation will start rising faster.

And that could have a big impact—even as big as the Saudis production gamble—on where oil prices are headed.

This article originally appeared in CNBC.

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