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Falling Oil Prices: Where Is the Floor?

Abstract:
The recent precipitous decline in world oil prices from $28 per barrel in November 1985 to $12 per barrel in March 1986 has perplexed most industry analysts and OPEC watchers. As oil prices continue to deteriorate, the central question now seems to be: "Is there a price floor below which oil prices will not fall; and if so, where is it?" Economic theory would suggest that at some price level, short-run marginal extraction costs of oil will eventually exceed marginal revenues from that production, leading to the widespread abandonment of the relatively higher-cost oil wells currently operated by competitive producers in non-OPEC areas. Presumably, once the price of oil falls to this floor, massive production cutbacks in high-cost, non-OPEC areas due to abandonment and reductions in new drilling activity would enable the lower-cost OPEC producers to significantly expand their market shares, thereby eliminating any incentives for further price reductions.

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Energy Specializations: Petroleum – Markets and Prices for Crude Oil and Products

JEL Codes:
L13 - Oligopoly and Other Imperfect Markets

Keywords: Oil prices, Volatility, Oil Leases, Oilwell abandonment decision

DOI: 10.5547/ISSN0195-6574-EJ-Vol7-No4-2


Published in Volume 7, Number 4 of The Quarterly Journal of the IAEE's Energy Economics Education Foundation.