Markets are shell-shocked as oil prices continue to drop due to a combination of oversupply and sluggish demand.

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No one is really sure where oil is headed, and analysts are rushing to build a consensus.

All oil isn’t created equal.

There are a number of different classifications for crude oil, including the Brent and West Texas Intermediate (WTI).

Brent Crude oil reached a peak of $115 a barrel earlier this summer before plummeting to a price of $82, a nearly 30% drop.

WTI Crude oil similarly tumbled, from a high of $105 to $79, a 20% drop.

Which raises the question: what is going on here?

There’s Too Much Oil!

The U.S. is experiencing an oil bonanza, displacing Saudi Arabia to become the world’s largest oil producer. It now supplies an average of 12.5 million barrels a day (mb/d), an increase of about 1.5 million barrels from its daily average in 2013.

wss1 (1)

Source: OPEC Monthly Oil Report, October 2014

But its not just the U.S.

Both Iraq and Libya have increased production as well, with the former Qadaffi-run state being a particularly interesting case. Libya was supplying some 800 thousand barrels a day (tb/d) in September, an increase of 250 tb/d from just a month previously!

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Source: The Economist

Libyan oil production may be running hot, but they are still only producing around half of what they were putting out in early 2013.

Meanwhile, Russia is keeping its output near record highs despite an environment of international sanctions and low prices. The former Soviet nation is currently producing about 10.6 mb/d.

Source: OPEC Monthly Oil Report, October 2014

Focusing on the most recent trend; both world oil supply and OPEC oil supply have been steadily rising since March.

Oil Demand is Weak

The plunging drop in oil prices isn’t just a supply side problem. It certainly doesn’t help that the world economy is hitting a soft patch. The Euro area is dragging its feet through the mud as oil demand lessens worldwide. The U.S. and Japan, two of the top five importers of oil, have also seen decreases in demand. According to OPEC, Japanese oil demand has been declining for five consecutive months as their economic woes continue.

The silver lining is that lower oil prices will stimulate growth, especially for net oil importers, where lower prices act as a sort of tax cut.

China buys more oil than it sells, and is the second largest net importer of oil in the world. A 20% discount on their energy bill works out to savings of around $60 billion! That’s a lot of dough.

Consumers stand to benefit as lower oil prices mean lower prices at the pump when it comes time to fill up. Drivers will be happy to find more money in their pockets to spend elsewhere. As a direct result, the economy will be stimulated as well.

Who Loses?

In many oil producing nations, the energy industry is the breadwinner. The profits from selling oil props these countries up and in many cases, allows them to keep going.

Countries like Iran, Venezuela, and Libya need oil prices above $100 a barrel to finance their government spending plans. Without reserves, these countries will struggle in the short-term.

On the other hand, rich countries like Saudi Arabia are cushioned from the blow of low oil prices. They can ride out an environment of low prices in relative comfort, but even they will have serious problems if low prices continue for an extended period.

The Saudis don’t seem content to ride it out though. Their actions, in cutting production by 400,000 barrels a day and increasing prices to Asian consumers, indicate that they are actively trying to exert upward pressure on prices.

Where do we go from here?

The last thing to consider is that many hedge fund managers are cutting their positions in oil. They went in for the long haul thinking oil prices would continue to go up and then start dumping their holdings as oil dipped below $90 a barrel. These actions will serve to depress prices further.

The investment bank Goldman Sachs forecasts that oil prices have further to fall, reaching $70 a barrel by next year before rebounding to $100 in 2016 as supply and demand forces work themselves out.

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