For the better part of this year, oil prices have dominated headlines.

The surge in oil production from American shale oil producers and the Organization of Petroleum-Exporting Countries (OPEC) has led to a corresponding reduction in price. This is not the first time that oil prices have dropped. Back in the late 1970s and early 1980s, the oil industry faced a similar situation when the entry of non-OPEC oil producers increased supply and, subsequently, decreased prices. In response, oil prices went precipitously south and dipped to $12 per barrel in 1986. Then, OPEC responded by cutting down oil production only to increase production later. Eventually, it took almost a decade for oil prices to stabilize. (For more, read: OPEC vs. the U.S.: Who Controls Oil Prices?)

The current downward swing in oil prices has raised a similar specter of low oil prices for a prolonged period. So far, this year oil prices have dropped by more than 57% from last year's prices. However, the decline may be temporary. According to analysts, oil prices will rise back up again in 2017.

A Supply Glut Which Led To A Price Drop

The main culprit for the shellacking that oil prices have received in recent times is the glut of oil in international markets. According to the U.S. Energy Information Administration, shale or tight oil production in America was 4.2 million barrels per day last year. That figure constituted approximately 49% of total production in the United States, the world's largest consumer of oil.

The increase in production and availability of oil here led to a glut of oil in international markets. The situation was further exacerbated by OPEC's removal of production quotas. Saudi Arabia, the swing producer in the oil market, has continued to maintain its production levels. American shale producers also refused to back down, continuing to produce oil to retain market share, even as oil prices dropped and made their methods uneconomical and unsustainable. According to the International Energy Agency, oil prices sank to six years lows in August due to increased supply.

The Case For A Temporary Increase

 Oil prices have declined primarily because of a reduction in supply. In a post on the Morningstar website, analyst Stephen Simko argues that “tens of billions of dollars of near-term investment has been cut or deferred, which will lead to global supply staying flat in 2016 -17.”

After peaking in April this year, U.S. oil production has declined swiftly since. Jefferies, a research firm, states that excess oil capacity has halved by a million barrels this quarter as compared to the previous one.

Much of the deferred investment takes the form of idling shale oil rigs and abandoning of new projects. According to Wood Mackenzie, an energy research firm, the move by oil firms to curb new investments could result in an estimated $1.5 trillion loss for the industry. For example, Dutch firm Shell Petroleum recently announced that it was stopping oil exploration in the Arctic after spending almost $7 billion on the project. Baker Hughes, an oilfield services company based in Houston, says the rig count (or the number of drilling rigs prospecting for oil) has fallen to its lowest level since 2003.

As U.S. production levels fall, other major players in the oil game, including Saudi Arabia, are expected to follow suit. Global demand, which has been rising for the past few years, is expected to increase further in the coming years. According to the U.S. Energy Information Administration, inventory builds for petroleum and other liquids is expected to decline to an average of 1.1 million barrels per day from current levels of 1.8 million barrels. At the same time, global demand for petroleum is expected to increase by 1.3 million barrels per day with China as the primary driver and the emergence of Iran as a major consumer. Juxtapose the demand increase with supply constraints and oil prices should stabilize and settle into an upward trend.

Finally, current oil prices are unsustainable for the long term future of oil. American shale oil producers find it uneconomical to produce oil at current prices. (For more, see: Will Shale Oil Companies Go Bankrupt?) OPEC producers are also under pressure from local budgetary constraints to spend more at home. Saudi Arabia, which has the world's largest reserves of oil, is also bleeding. It's foreign reserves are declining, and the country has also had to withdraw $50 billion to $70 billion in the last six months from global asset managers, according to market intelligence company Insight Discovery.

The Bottom Line

Unrestrained drilling by U.S. shale oil producers caused a glut in oil supplies. In turn, prices increased. Declining U.S. oil production should instigate other major producers to drop their prices. In turn, an increase in global demand should drive prices upward.    

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