2008
In late 2006, OPEC began reducing production due to its concern with growing crude and petroleum products inventories. This, in conjunction with accelerating demand from an increasingly prosperous China, and the proliferation of petroleum backed derivatives, drove oil prices to a record $145 on July 3, 2008. By December, as the credit bubble burst, oil touched $40 a barrel; many nations, including the US, were concerned with financial system survival. Production cuts abounded in 2009 and oil recovered in a V shaped pattern. Price momentum continued in the face of the Libyan civil war in 2011 and stayed above $80 per barrel for four consecutive years until the fall of 2014.
2014
Complacency was probably at its height mid-year. There were few market pundits predicting the 50 percent decline in crude in the last several months. But unusually acerbic rhetoric from Saudi Arabia’s oil minister in the last several weeks regarding their posture on maintaining market share at any cost shocked the market. The outcome of a strategy focused on production ramp in a falling price environment almost always results in a protracted cycle of price and political destabilization. Some speculate OPEC’s tactics could have been political. The Saudis could be taking punitive measures against the US for the substantial incremental supply that unconventional drilling (fracking) has created in recent years, making the US and the rest of the world less dependent on OPEC oil supplies. Or they could be punishing Russia for dissension in the quota creation process. As the second largest and one of the higher cost oil producers/exporters globally, Russia is particularly vulnerable to falling crude prices. The last several months’ price action has severely destabilized the ruble, forcing the State Duma to pass emergency legislation and nearly double borrowing rates to thwart a run on the Russian currency and banking system. Perhaps OPEC’s strategy is to regain market share by sending sizeable but vulnerable producers like Russia
and Venezuela into an economic and financial tailspin.
OPEC’s decision to maintain current production may have been a catalyst for oil’s most recent downdraft, but subtle changes in the supply/demand curve in the last year set the stage for the rout. In the last year or two, Europe’s stagnant and China’s slowing economies have weighed on demand for oil. Simultaneously, marginal supply growth from US fracking and an unanticipated rebound in Libyan supply have created excess stores of crude. The supply/demand curve is price-inelastic, meaning a relatively small change in production or consumption has an outsized impact on price. Since there are no readily available substitutes for oil in the short run, a spike in the price of oil does not reduce levels of consumption significantly. Airlines still fly and people still drive their cars, though they may grumble more. Conversely, if crude prices decline, people don’t automatically consume more. Supply is also slow to adjust. Oil exploration and production involves long lead time projects with fixed costs and debt obligations.
Most global pricing dislocations are either event driven (war, supply disruption) or reflect a slow build of evidence capped by a catalyst that drive the direction and probability of price movement. Thus most recently, a bit more shale oil and a marginally lower China GDP, combined with pessimistic comments from the Saudis, shifted sentiment from complacency mid-year, to caution in the early fall, to panic most recently. Shadow leverage from commodity-backed derivatives probably magnified the downdraft. However, one should not get too used to cheaper oil. In the long run, low oil prices erode the conditions that bring them on. Cheap oil stimulates the economy resulting in increased energy use. The windfall to consumers tends to be short lived. Volatility is here to stay and the ability to drive or predict oil prices in the short term is all but impossible. At this point, the least popular crude scenario in 2015 is a return to $100 plus prices; economist consensus is for stable to lower prices in the coming year, as the path of least resistance is extrapolating the current environment. Given the strength in the US economy, continued low interest rates, broad access to capital and more conservative than forecasted crude capital expenditures, we would not be surprised to see oil prices significantly higher as the year progresses.
Marian Kessler joined Becker Capital in 2004. She has more than 20 years of experience in the investment business as an analyst, portfolio manager and managing director of IDS/American Express, Safeco Asset Management and Crabbe Huson.