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The current oil prices puzzle- for a layman’s understanding

As a professional engineer working in Saudi Oil & Gas market, I came across questions about oil price. Why it is going down these days? What this has to do with OPEC and USA? Will Saudi Arabia get in trouble due to this price slump? If it is about USD 50 these days, why it was over USD 100 last year? And the list goes on. Due to more awareness, people now understand that even if they are not connected with Oil & Gas sector directly, oil price is something which is affecting their monthly budget on regular basis. That’s why they develop interest about oil price and try to understand current scenario. Moreover, people also want to know why serious commentators aren’t ready to give credit to govt. for reduction in oil prices and still accusing govt. for over pricing.

I will try to explain current oil price scenario with simple words and daily life example. Hope it helps the readers.

There are multiple sellers of onions in local market who sell onions more or less at the same price on a given day, at a given place. For example, take Rs. 10 per kg. Buyers have nothing to do about the cost of production that different sellers bear. Sellers try to minimize their cost of production to maximize their profits. If onions are sold for Rs. 10 per kg, one seller can’t start selling it for Rs. 20 per kg. If he does so, people will stay away from him and will prefer other sellers. Consider the same scenario when oil price was USD 110 per barrel last year and different sellers were playing their cards in international market.

Somehow one of the sellers, say Ehsan, finds technique to reduce his cost of production drastically say by 50%. Before this technique, his cost was Rs. 7 and he was getting Rs. 3 per kg as profit. Now his cost is Rs. 3 and onions price is still Rs. 10 per kg that provides him Rs. 7 per kg as profit. He is a smart player though, and he decides to make most of his new technique, hence he starts selling onions at Rs. 7 per kg. As a result, though his profit reduces by margin of Rs. 3 per kg but he is selling more onions than the whole market combined. People are rushing towards him because of lower cost whereas other sellers are trying their level best to bring down their cost to remain competitive in the market.

There are sellers who can bring down their cost a bit and can manage their cost at Rs. 6 per kg that allows them Rs. 1 per kg profit if they also start selling for Rs. 7 per kg. However, they will find it difficult to maintain business with such low profit margin. Their only hope of survival is that Ahmad is unable to supply enough onions that can meet market demand. This way, buyers will have to go to other sellers as well and Ahmad has run out of stock. Let’s name the closest competitor, operating at the cost of Rs. 6 per kg as Faisal. Faisal has now two options; one is to make cartel with Ehsan i.e. they decide they will not sell lower than Rs. 9 per kg. Other option is to somehow cut down his cost further to gain more profit.

However, there are other factors on play as well. Ehsan doesn’t sell onions only, it is one of his businesses, he also sells tomatoes, potatoes, apples, etc. etc. As a result, he is not totally dependent on onion business which allows him better margin to play in onions market. On the other hand, Faisal is limited to onions business only and it makes life even tougher for him. Moreover, Ehsan has also a lot of other advantages over Faisal. Ehsan has got better reputation, his business is more stable, volume of his business empire is way large than that of Faisal, he is more influential than Faisal, buyers need favors from Ehsan for other businesses as well, etc.

Now replace Ehsan with USA, Faisal with OPEC and that new technique is Shale Gas extraction that has allowed USA to flood Oil & Gas market at lower price than competitors. USA is not completely dependent on oil like most OPEC countries that allows USA to keep selling at lower price with even lower profit margins. Among OPEC countries, different countries have different cost of production, that’s why only KSA is a real competitor to USA in oil and gas international market as it has got big reserves with lower cost of production.

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