To everyone’s surprise, international crude oil prices have fallen almost 40pc over the past five months. Having hovered around $100 a barrel for almost three years, oil is now trading in the region of $60.

As late as May, market analysts were confident that prices would remain around $100 per barrel until at least the end of 2014 and beyond, because demand and supply were expected to remain balanced.

There was, nevertheless, a slight but nagging fear of a slowdown in the global economy at the same time, particularly in China, that could lead to reduced demand for oil and thus upset projections of price stability. In the end, there was an economic slowdown not only in China but also in the eurozone and large emerging economies such as India and Brazil.

However this is not the only reason for the steep and rapid fall in oil prices. While the slowdown in global economies can only result in a short-term decline in demand for oil, the significant factor that points to lower oil prices in the future is the abundant supply from the US, where availability of indigenous shale oil has been multiplying over the past five years.

This has been made possible by the tremendous progress made in the development and application of technologies of ‘fracking’ (hydraulic fracturing), and horizontal drilling. These combine to allow extraction of oil deposits that were earlier considered inaccessible or prohibitively expensive to reach. Other countries too are embarking on such projects.

Saudi Arabia’s production cost is $30 a barrel, so it can turn in a sizable surplus even at these low prices. Shale oil production, on the other hand, is only feasible if oil prices stay at $85 a barrel

It is this shale oil boom that has helped cushion crude oil and gas prices against geopolitical shocks. “Because of that production”, says a petroleum analyst, “we didn’t see significant price hikes in both retail gasoline and crude oil prices when we saw the fall of Mosul in Iraq, problems with Russia and Ukraine, and air assaults to retaliate against ISIS. These are events that in past years would have caused significant spikes.” Another reason is Saudi Arabia. =copied from Christian Science Monitor report.

It is important to remember that it was high oil prices, at more than $100 a barrel, that fuelled heavy investment in shale oil production. During most of the past decade, Saudi Arabia came forward as the ‘swing’ producer, lowering or increasing production from its fields in order to stabilise prices.

However, it does not appear to be willing to intervene in the present crisis. In a move designed to signal that it is more interested in maintaining its market share than in defending prices, Saudi Aramco stunned markets by announcing in early October that it was cutting prices by about $1 a barrel to Asia, the crucial growth market for Persian Gulf producers, as well as by 40 cents a barrel to the United States.

The Organisation of Petroleum Exporting Countries (Opec) was expected to arrest the decline in oil prices by announcing production cuts in its meeting in Vienna on 27 November. But it decided to maintain its current production levels, sending oil prices into a further tailspin.

This decision was agreed to reluctantly by members like Iran, Nigeria, Venezuela and Ecuador, which see shrinking oil revenues, and its negative impact on their economies, as a threat to political stability. Furthermore these countries have much higher costs of production than Saudi Arabia and the Gulf sheikhdoms, and in some cases current oil price levels have made some of their wells uneconomic.

It is clear that it is Saudi Arabia that is spearheading the free fall in oil prices by driving them down sharply to a level below the cost of shale oil production. Saudi Arabia’s production cost is $30 a barrel, so it can turn in a sizable surplus even at these low prices. Shale oil production, on the other hand, is only feasible if oil prices stay at $85 a barrel. Tumbling prices have already led to many shale oil projects being shelved, and many fewer are being planned.

Saudi Arabia, with foreign exchange reserves of $1trn is well-placed to endure this period of falling revenues, and achieve its primary objective of retaining its market share in an era of shrinking demand for oil.

However there is very little spare capacity in conventional crude oil production. Once economies recover, the demand for oil will accelerate and drive up prices again to a level that makes shale oil production feasible. Should Opec and shale oil producers enter into a price-sharing agreement in order to avoid such great and disruptive market upheavals in future? This is a matter that merits consideration.

Published in Dawn, Economic & Business, December 15th , 2014