One of the defining economic events of 2014 has been the dramatic decline in crude oil prices over the last six months. Prices have fallen 45 percent to their lowest levels in 5.5 years. This precipitous decline, which was unexpected as oil prices stabilized around $100-$110 a barrel during the three years prior to mid-2014, will have global, political and economic ramifications for consumers, governments, industries and central banks.

Various types of crude oil are produced in many locations throughout the world. Most of the oil produced today comes from conventional onshore vertical wells that have been around since the late 1800s. While still the majority globally, conventional oil has been in a steady decline in the U.S. since 1974.

The U.S. and other countries innovated and developed unconventional sources of oil: deepwater oil, shale oil and tar-sands oil. The U.S. has been particularly successful in developing hydraulic fracturing (fracking) and horizontal drilling to produce more oil in the U.S. as had Canada in developing the tar sands in Alberta.

On the global stage, oil is priced in U.S. dollars. There are two major price benchmarks: Brent from oil produced in the North Sea and West Texas Intermediate (WTI) from U.S. produced oil. Brent is more of a global price while WTI is the U.S. price. The Brent and WTI prices are highly correlated and usually differ by no more than a few dollars; WTI usually sells at a discount to Brent. In 2014, both Brent and WTI have fallen by more than 45 percent.

It is not the first time this has happened as crude oil prices fell from $147 per barrel in 2008 to $40 in 2010. Every decade since 1980 has experienced a dramatic rise and decline in crude oil prices.

Crude oil is a commodity whose price is determined by the forces of supply and demand, and is very sensitive to any imbalances. The current decline in oil prices is thought to be more supply than demand driven, but both have played a role. On the supply side, current daily production is about 92 million barrels; daily demand is 91 million barrels. As a result, there is a crude-oil glut of about 1 million barrels per day which has forced both Brent and WTI prices down in the last six months.

In the past, excess oil supply would have been handled by the Organization of Petroleum Exporting Countries (OPEC), which today produces about 30 million barrels per day, about one-third of world production. Saudi Arabia is the largest producer within OPEC at about 9.6 million barrels per day, followed by Iran, Iraq, United Arab Emirates and Kuwait at about 3 million barrels per day.

Even though OPEC includes countries from Africa and South America, Middle East countries dominate OPEC production. Since its founding in 1960, there has always been infighting among OPEC members who decide behind closed doors when to cut or increase their collective output to influence oil prices. But in recent months OPEC has been in complete disarray as divisions have deepened significantly.

This has resulted in a decision at the November OPEC meeting not to cut production in the face of excess supply of crude oil. Saudi Arabia, as the largest producer, was the OPEC member that in the past was expected to cut production to stabilize prices; they said no to a production cut, but it was not a unanimous decision by OPEC members.

Why would Saudi Arabia not agree to a production cut?

In the past, when OPEC has agreed to collectively cut production, some members have cheated and not followed through at the expense of Saudi Arabia, which lost market share. Other reasons are geopolitical. Saudi Arabia is not on good terms with Russia and Iran. Both countries are already in recession and facing U.S. and European sanctions. A plunging oil price will dramatically affect those countries’ economies much more than Saudi Arabia.

Most OPEC members depend upon oil to finance a large part of their fiscal budgets. There is a cost production price per barrel and a budget price needed to fund the budget. For example, Venezuela needs oil prices to be at $160 per barrel to balance its budget and Iran needs $130 per barrel. Both are OPEC members and desperately wanted Saudi Arabia to cut production.

Russia is not an OPEC member but needs $110 per barrel to balance its budget. At current oil prices, many oil-producing countries are in dire straits and will have difficulty funding budgets. Even though Saudi Arabia can produce oil at $6 per barrel, it needs $90 per barrel to balance its budget; but it has nearly $1 trillion of foreign exchange reserves to ride out the decline in oil prices.

Saudi Arabia has another reason to not cut production. While a friend of the U.S. and Canada, they would like to lessen future competition by halting shale-oil production and development of tar-sand oil in Canada. U.S. oil production has increased from 4.7 million barrels per day in 2008 to 9 million barrels today. Most of the increased U.S. production has come from shale oil.

What also worries Saudi Arabia is that countries such as China and Russia have even more shale-oil reserves than the U.S. that have not yet been developed. It has been estimated that $100-per-barrel oil is needed for the Canadian tar-sands mining operations to be commercially viable. If so, the Keystone XL pipeline will not be needed at current oil prices. Plus deepwater oil from the Gulf, Norway, Brazil, the UK and other countries is expensive oil and companies will not invest in further development at current prices.

U.S. shale-oil production has been transformational and has eroded the influence OPEC has on global oil prices and the U.S.

The U.S. imported 10 million barrels per day in 2008 versus 6.5 million barrels per day in 2014. U.S. imports of oil from OPEC countries are at a 30-year low, at 2.9 million barrels per day. This represents 45 percent of imported oil from OPEC versus 88 percent in 1976. The U.S. has cut oil imports to zero from Nigeria and other countries, and drastically reduced imports from most countries except Canada and Mexico.

It is not unrealistic to assume that the U.S. could be North American oil independent with further development of shale oil, tar-sand oil and deepwater oil. But it will not happen at current oil prices. A good reason for Saudi Arabia not to cut production. It’s coming down to a battle between the Arabian sheiks versus shale.

While supply has been responsible for most of the dramatic decline in oil prices, the demand side has also not helped. One would expect demand to increase as oil and gasoline prices decline, but that has not happened and probably will not in the foreseeable future for several reasons.

Slow global economic growth, particularly in Europe, and slowing Asian economic growth, particularly in China, have dampened oil demand as has government-mandated fuel efficiencies for new cars in the U.S., Europe and Asian countries. Many utilities in the U.S. have replaced oil and coal with natural gas in electricity production.

Another reason demand has not picked up with lower oil prices has been the strong U.S. dollar. As noted earlier, oil is denominated in U.S. dollars so a strong U.S. dollar makes oil more expensive for consumers in oil-importing countries. Take Japan as an example; at 80 yen per dollar and $100 oil, it would take 8000 yen to buy a barrel of oil. As the price of oil falls to $60, 6000 yen would buy a barrel of oil. However, the yen has depreciated relative to the dollar to 120 yen per dollar resulting in 7200 yen needed to buy a $60 barrel of oil.

While the price of oil has fallen by 45 percent in U.S. terms, it has fallen by only 10 percent for Japan. The U.S. dollar has appreciated against almost all currencies in the world except those currencies pegged to the dollar, such as the Chinese yuan, canceling out the demand impact of falling oil prices. Plus some countries such as Thailand and Indonesia have phased out gasoline subsidies so consumers would have paid even more for a gallon of gasoline regardless of oil prices.

What does cheap oil mean for the world? The IMF estimates that a 10 percent change in the price of oil results in a 0.2 percent change in global economic growth. The current drop in prices means $1.8 trillion will move from producers to consumers in 2015, stimulating economic growth.

But the impact is different in oil-exporting countries. The effect on some countries, such as Nigeria, Russia and Venezuela, will be extremely adverse.

On a net basis, it certainly is positive for the U.S. consumer; at current prices each household will have an additional $800-$1,000 per year to spend on other things. It will also be a positive for Europe, whose economies are struggling, and Asia, whose economies are slowing.

Some industries that are energy-intensive or use oil as a cost input will also benefit. Central banks will have more flexibility in setting monetary policy as the decline in oil prices adds to already present deflationary pressures. So interest rates may stay lower longer.

Energy has been an area of strength, especially in the U.S., in terms of capital expenditure and employment. That will be one negative of lower oil prices. Another will be increased geopolitical risk in the world, as some companies face fiscal austerity, hopefully not like the Arab Spring.

The International Energy Agency has cut its estimate of 2015 oil demand five times in the last six months, saying the rout in oil prices has failed to stimulate demand. Given that the oil spigots cannot be turned down quickly, Saudi Arabia’s resistance to a production cut, the U.S. shale-oil boom, and the potential for 2-3 million more barrels of daily production from Iran, Iraq and other countries, prices could decline further before they stabilize.

In the longer term, investment in energy exploration and production will be curtailed as already planned by most oil producers. As supply declines and demand eventually increases, the price of oil will eventually go back to $100 per barrel. It is difficult to see that happening in the next couple of years.

Perhaps prices will settle in under $60 a barrel for a long period of time, which occurred in the 1980s and 1990s. But one thing you will not hear much talk about is “peak oil” and how the world is running out of it. Innovation and technology have moved the time of the peak in oil production out several decades.

Including natural gas, the U.S. has become the largest energy producer in the world. It has long been the largest exporter of petroleum products, such as gasoline, refined oil, diesel fuel and others.

In 1970 Congress passed a law prohibiting the export of crude oil from the U.S. In 2014, several firms were given permission to export oil — but not at a meaningful amount. At the right price, the U.S. could become a major exporter of crude oil as well as liquefied natural gas. This may become a hot political issue in coming years.

Whatever the outcome of current events, it’s a positive to not have to import 10 million barrels of oil daily and 88 percent from OPEC. The U.S. has come a long way in energy sufficiency and efficiency.

About The Author Robert Klemkosky

Robert C. Klemkosky is professor emeritus of finance at Indiana University Kelley School of Business. He was the founding dean of SKK Graduate School of Business at Sungkyunkwan University in Seoul, a top MBA program in Asia, and currently is chief investment strategist at Wallington Asset Management, an Indianapolis-based money management firm.