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Explaining the global oil-price drop
The Middle East is burning
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he Middle East is burning. Jets fighter from Saudi Arabia, Jordan, the United Arab Emirates (UAE) and Egypt have attacked numerous Islamic State (IS) movement targets in Syria, Iraq and Libya, mainly in response to the sadistic killing of a captured Jordanian pilot, Moaz al-Kasasbeh.
In this hostile conflict, begun in June 2014, oil prices have dropped significantly, from the highest level of more than US$100/barrel in 2010 to approximately $50 this year.
Yet Saudi Arabia, the biggest oil producer in the Organization of the Petroleum Exporting Countries (OPEC) did not do anything to cut oil supply, to stabilize prices.
The outbreak of massive arms conflicts in the Middle East usually results in a rise of oil prices as oil supply to the global market is disrupted, but not this time. This article highlights three views that explain the drop of oil prices in the global market.
First is the security explanation. IS emerged in 2013 from different groups that shared a temporary common interest, toppling Bashar al-Assad in Syria. Later it became a threat of oil-rich countries in the region as their main interest was under attack.
This is especially since it began to adopt a strategy using oil as a 'weapon' on a significant scale by attacking and seizing major oil fields in Syria and Iraq since April 2014, i.e. Jafra, Omar, Tanak and Ain Zalah.
IS uses its income from oil to pay its combatants and to buy weaponry. When the oil price was at a level of $100, IS sold it at $20/barrel on the black market.
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 with IS.
Iraq and Syria are the very battleground in the confrontation against IS, as these territories are where IS, also known as the Islamic State of Iraq and the Sham/Syria (ISIS) is intended to be erected. Nonetheless, the other three monarchies believe that they will be the next target of IS.
Accordingly, Saudi Arabia, the UAE and Jordan launched several air assaults on territories and oil fields that were seized by IS. Defeating IS is a principal interest of these monarchies.
However, to ensure this they need to cripple IS economically. Among these three, only Saudi Arabia has the ability to use oil as an economic weapon against IS, as it is the biggest oil producer in OPEC.
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Investors were nervous because several major oil fields had been controlled by IS.
When the price of oil is as low as $50/barrel, then IS will have difficulty selling it on the black market at a reasonable price.
This would cripple IS economically, which would then weaken its combat ability.
Nonetheless, 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 socioeconomic impacts caused by the strategy.
Nevertheless 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-Shiite rivalry and it has become common knowledge that Russia supports Iran and its military wing Hezbollah in Lebanon with weaponry.
Second is global economic conditions. The major source of global economic growth is the Triad (the US, EU and Asia, especially China). All of them, in different proportions, rely their economy 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, but also vice versa.
The Euro-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, including with its new national leadership.
The EU is still trapped in the dispute 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 percent, this is lower than its performance before the outbreak of the global crisis in 2008 when it could reach a level of about 10 percent. The slowdown of China's economy resulted in the drop of oil demand.
The US, despite its slow recovery as indicated by the decline of its unemployment rate to the level of approximately 6 percent, is also still marked by slow growth.
Another development that needs to be underlined here that affects the demand of oil from the US is the successful commercialization of shale gas as a new source of energy. This new invention has sharply cut American oil imports.
And the third is the financial market condition. Conventional wisdom saying that the price of goods is determined by supply and demand is only a partial realm of today's global economy.
The price of goods is now 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 imbalanced 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 also vice versa.
The global financial crisis of 2008 started in the very heart of the global economy, Wall Street in the US. 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 of oil prices, from about $60/barrel to more than $100 in 2009.
This was not caused by a steep increase in oil demand, but rather because money that was invested in the US capital market found a better place of investment in financial products that related to oil.
This was also what had happened since June 2014, only with the opposite effect, resulting in the drop of oil prices.
Investors were nervous because several major oil fields had been controlled by IS, making investment in that sector risky. This functions as a push factor.
On the other hand, there have been attractive pull factors in the US. The recovery of the US economy is an important factor, although it happened slowly.
Another important factor is the introduction of a series of quantitative easing (QE) polices, which make bonds and stocks in the US become more attractive, and statements from the US Federal Reserve that it will raise its fund 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 of oil prices that started in June 2014 is shaped by a set of complex reasons it is unlikely that it would bounce back soon, forming its new equilibrium.
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The writer is a lecturer at the Catholic University of Parahyangan, Bandung, and a member of the Parahyangan Centre for International Studies.
