The price of crude oil, adjusted for inflation, is at 1979 levels, having fallen by more than 50% since June 2014.

Weak demand contributes perhaps 30%-40% of the fall. In 2014, oil demand grew by around 500,000 barrels per day, below the 1.3 million barrels of growth projected earlier, reflecting slack economic activity in Europe, Japan, and emerging markets, especially China.

Increased supply accounts for 60%-70% of the decline. High prices and strong demand encouraged new sources of oil to be brought on stream. The U.S. alone has added 3 million barrels a day of new supply in just the past three years, the equivalent of adding another Kuwait to the world oil market.

Oil may chill U.S. earnings season

The increased supply has been exacerbated by the refusal of OPEC, led by Saudi Arabia, to cut output for strategic and geopolitical reasons.

OPEC, the industry cartel through which Saudi Arabia traditionally exerts its influence, is in decline. OPEC’s market share has fallen from more than 50% in 1974 to around 40% currently. Compounding OPEC’s problems are efforts to diminish the role of oil as a transport fuel. The poor financial condition of some OPEC members makes it hard for them to reduce production, exacerbating the decline of the cartel’s power and its ability to dictate prices.

From the Saudi perspective, the primary benefit of high oil prices has accrued to non-OPEC members. A cut in Saudi or OPEC production to support prices would only further benefit these oil producers. The Saudis are mindful of history. In the mid-1980s, Saudi Arabia cut its output by close to 75% to support weak prices. The Saudis suffered a loss of both revenues and market share. Other OPEC members and non-OPEC producers benefitted from higher prices. In recent years, Saudi Arabia has regained market share, benefitting from the disruption to suppliers such as Iran, Iraq and Libya. The Saudis are reluctant to cut production, preferring to maintain market share rather than prices.

The strategy is to allow oil prices CLG25, to fall to levels below production costs of high-cost producers and non-traditional oil sources. The average breakeven cost currently is probably between $60 and $70 per barrel. Importantly, U.S. shale oil may not be economically viable below those levels. Perhaps as much as 80% of shale reserves are uneconomic at prices below $80 per barrel, at least based on current technology.

In the short run, producers may continue to produce and sell at below breakeven prices. If oil prices stay low for a sustained period, then producers will cut production, with marginal- or higher-cost firms forced to close or declare bankruptcy.

Most importantly, irrespective of production level changes, expansion and new investment will be wound back. For example, oil above $100 a barrel would allow deep water reserves, Arctic oil, tar sands or shale deposits in countries including Canada, Poland, Argentina and Venezuela to be profitably developed. Lower prices will make these uneconomic. The lack of investment capital will ultimately reduce immediate supply and the potential resources for future production worldwide.

Satyajit Das Newman Communications via Bloomberg

In theory, Saudi Arabian oil and foreign policy are separate. In practice, they are related. Low oil prices hurt Iran, Saudi Arabia’s competitor for Middle East political influence. It is revenge for Iran’s support of the Shiite factions in Iraq, allegiance with Syrian leader Bashar al-Assad and its destabilizing nuclear program. Low oil prices also hurt Russia, which also supports Syria and Iran. Low prices also undermine the financial basis of Islamic State militants, whose sales of cheap smuggled oil funds their military activities.

Low oil prices can be seen through a Saudi prism as reprisals against the U.S. It is designed to undermine American attempts at greater energy self-sufficiency through aggressive exploitation of its shale gas and liquid resources. It is revenge for America’s strategic rebalancing away from the region to a greater Asian focus. The oil strategy is a signal from Saudi Arabia that it still wields significant power on the geopolitical stage.