How low can oil prices go? The tricky geopolitics of tumbling demand and rising supply.

• Author: Bailey, Ronald
• Position: Columns - Column

THE PRICE OF OIL in global markets has plunged by nearly 45 percent over the past six months. As a result, the price of a gallon of regular gasoline in the U.S. dropped from $3.68 in June to $2.37 in late December. In June, the U.S. Energy Information Administration had projected that a gallon of gas would average $3.48 per gallon in the second half of 2014. What happened? And where might oil prices go in the next two to five years?

We are awash in crude oil even as the world economy is slowing down, leading to lowered demand for crude. The glut in global production stems largely from the fracking boom in the United States, which has seen domestic oil production rise from 5 million barrels per day in 2008 to over 9 million barrels per day in November 2014. The predictable result of increased supply of petroleum is that the price is down: A barrel of benchmark West Texas Intermediate crude hovered around at the end of December.

Over the Thanksgiving holiday, the Organization of Petroleum Exporting Countries (OPEC) declined, reportedly at the behest of Saudi Arabia, to reduce its members' production. Some analysts have suggested that the goal is to keep global oil prices low, thereby killing off fracking in the United States and preventing the drilling technique's spread to other parts of the world. It costs less than $10 per barrel to get oil out of the ground in most Middle Eastern countries, whereas production costs hover around $65 per barrel for U.S. fracked wells.

Michael Lynch, an analyst at Strategic Energy and Economic Research, thinks this strategy is unlikely to work. Lynch estimates that most fracked wells in the U.S. break even below $60. Although he says sustained lower prices are likely to cut future drilling investments by 10 to 15 percent, even that has an upside, because slackening demand for drilling rigs and crews will lower the costs for new fracked wells. In addition, technological improvements along with offsetting increases in production are reducing fracking costs by something like 10 to 20 percent annually. In any case, owners will pump oil from wells already drilled as long as production covers their variable costs.

Lynch argues that during the first decade of this century, oil prices were affected by the perceived threat to production capacity caused by strife in places like Iraq, Nigeria, Iran, and Venezuela. In effect, purchasers paid a security premium. He now believes, despite the continuing turmoil in the...