With oil prices plummeting to five-year lows, there is now growing concern that lower oil prices could undermine Russia’s economic development in the future.

An oil well pump operates in Boca de Jaruco, Cuba, Friday, July 11, 2014. Russian companies are expected to participate in petroleum projects around Boca de Jaruco on the island's north coast, and that cooperation will extend to offshore oil deposits, Cuban government website Cubadebate said. Photo: AP

After the Gulf countries announced at the Nov. 27 OPEC summit in Vienna that they wouldn’t take steps to cut production, oil prices plummeted to their lowest level in more than five years. As a result, Russia started worrying even more because oil prices determine Russian economic stability. Nearly half of primary energy resources produced in Russia are exported, and these energy resources account for a major share of Russia’s balance of payments and state budget.

Therefore, the impact of lower prices is significant for Russia’s budget. Will oil prices now stay at these low levels? And to what extent will these lower oil prices undermine Russia’s economic development in the years to come?

OPEC, which produces some 40 percent of world oil, has extensive experience in affecting the level of prices. Throughout the 1970s and 1980s, the oil market almost entirely depended on the interests of OPEC member countries. The price was not a market price and was determined by their actions – this was allowed through the oil market’s institutional structure.

The world today is not the same.

Firstly, OPEC now is the biggest, yet not the only major player in the oil market. The share of non-OPEC producers is steadily increasing. “OPEC no longer rules supreme: America is now a bigger oil producer than Saudi Arabia. But it is still the biggest force in the world oil market,” notes The Economist.

Secondly, the pricing principle has changed. Since the mid-1980s, with the transition to price formation via oil exchanges, oil prices are closer to prices actually reflecting the balance of supply and demand. This is true despite the influence of speculative factors, which also came about as a result of this institutional change in the way the oil market operates.

The previous case of such an intervention when OPEC members introduced production cuts was throughout the 2008 economic crisis, when, in a matter of just a few months, the oil price dropped by 70 percent. By way of comparison, the current fall in prices is around 30 percent. Secondly, the price is within the range sufficient for most OPEC producers. This means that the price of $70 per barrel is sufficient for OPEC producers to cover their costs.

Thus, among the reasons that prevented OPEC from introducing production cuts, we can name the following:

 - The lack of immediate consensus amongst OPEC members;

 - Overall the price level still exceeds the break-even points for producing fields;

 - Opportunity to retain market share.

Ultimately, all players are interested in a structure of the oil market that would give them signals concerning their demand levels (in case of consumers) and the needed investment and supply levels (in case of producers), and it is not in their interest that the price – the key market signal – could be manipulated by any single player.

There are a lot of debates concerning the level of price that is right. To explain what the oil price should be, the so-called equilibrium prices concept should be taken into account. Equilibrium price is the price at which oil production – both conventional and unconventional, ‘cheap’ and ‘expensive’ – satisfies demand. In other words, it is the price at the intersection of the supply and demand curves, the right price. If one knows the volume of demand and costs along the supply chains, one can calculate what this equilibrium price dynamic is over time.

Is this just a theoretical construct? Not necessarily. The Energy Research Institute of the Russian Academy of Sciences (ERIRAS) and the Analytical Center for the Government of the Russian Federation (ACRF) in their report “Global and Russian Energy Outlook Up to 2040” have compared the equilibrium price of oil and the factual price. They found that during the 2000-2010 period, the factual price has largely reflected the balance between supply and demand at the cost of recovery of oil used to cover that demand, i.e. the correlation coefficient between them was high.

It’s important to specifically stress this in light of arguments used in a recent Russia Direct column that suggested that the factual price and the equilibrium price were in divergence. “The $100 oil of recent years was driven by political uncertainty, not fundamental supply and demand,” writes Edward Chow.

Simple analysis demonstrates that, indeed, most oil (more than 4 billion tons), can be obtained at prices even below $90 per barrel. This includes conventional oil and liquid natural gas (LNG), as well as U.S. shale and tight oil plays and Canadian tar sands. However, this volume is clearly insufficient to cover demand, which, in turn, causes deposits to be included in the supply balance that are more difficult to extract and more expensive as well.

Based on the demand outlook, the world will not decrease its hunger for oil. For example, the International Energy Agency is projecting an increase in oil demand in the run up to 2040, albeit a very modest increase. Therefore, the price has to be at the level to be able to cover expenses of the margin producers – whether it is Russian fields or any other hard-to-recover area, including deepwater or remote areas.

Summing up, the current oil price is below the equilibrium price, which is a balance between the volume of world oil demand and the costs incurred in production of oil needed to cover that demand. It is of course immediate bad news for margin (high cost) producers, including Russia, which is troubled not only by low oil prices but also by the falling ruble exchange rate and the economic outcomes of Western sanctions.

An absence of agreement concerning OPEC output cuts will almost certainly send the oil price tumbling further. The drop in prices will have effect on both production and demand: downward pressure on investment versus upward pressure on demand, which in the medium-term, will inevitably lead to the recovery of price to a level closer to equilibrium price.

What’s in all this for Russia? I would argue (again, as I have done in my other piece related to the impact of sanctions), that the problems inherent to the Russian economy became more evident and acute than ever throughout the year 2014. The threat of underinvestment became apparent already in 2013. Underinvestment in turn limits the potential for growth. The key problems of the Russian economy are low efficiency in the use of labor and capital, a low shares of services and products with high added value, and finally, overall high costs. All of these factors impede internal development, and Russia has to search for a new model of economic growth.

The opinion of the authors may not necessarily reflect the position of Russia Direct or its staff.