Making Sense of Falling Oil Prices

EIA net energy imports lowest in 29 years

SOURCE: US EIA
World oil prices have fallen by 30% since their June 2014 high of about $115 per barrel. As I write this on October 15th Brent crude, the global benchmark, is at about $84.88 per barrel. WTI, the US benchmark is at $81.58 per barrel. This rapid fall in oil prices has spooked the market and set off actions and reactions that only contribute to the volatility. The predominant fear in the market is that prices will continue to fall and wreak havoc around the world.

So what is driving this market volatility in oil prices?

The answer appears to be that a combination of :

  • Global Economic Growth Factors including weaker GDP growth in China, Europe especially Germany and Russia, combined with an end to US Federal Reserve Bank quantitative easing (QE) program of flooding the market with money and with it worries that record high NYSE levels are being propped up by QE and this will fall when it ends.
  • Consumers are Cheering Lower Oil Prices. Oil is traded around the world in US dollars. A strong dollar tends to be bad for commodity prices especially in emerging countries with big commodity extraction and export business. Lower oil prices combined with a strong dollar ought to put downward pressure on commodity prices. This can be a double-edged sword as lower commodity prices benefit some companies while hurting others where they eat into margins or make US products less competitive in global export markets.
  • Oil Market Fundamentals where supply growth outpaces demand as US shale production continues and oil from Libya and Iraq come back to market putting downward pressure on prices. Global oil supply rose by 910,000 bpd in September to 93.8 million bpd, that is 2.8 million bpd higher than a year ago, according to the International Energy Agency (IEA)..
  • IEA Cut Oil Demand Forecast for 2015. The IEA cut 300,000 barrels per day from 2015 forecasted oil demand growth. IEA also revised its 2014 oil demand estimate down by 200,000 bpd to 0.7 million bpd.
  • From Backwardation to Contango Market Sentiment. Rising oil supply growth market sentiment from one expecting higher future oil prices (contango) to expecting lower future prices (backwardation) as Brent oil prices fell below $105 per barrel with more oil coming to market even when demand is weak. For oil speculators especially those with oil storage floating in ships waiting for higher prices this is the ‘catch a falling knife’ scenario. The IEA piled on to this pessimistic (from an oil sellers point of view) market sentiment saying world oil demand only supported prices around $88 a barrel 25% below the $115 per barrel price in June 2014. Why? IEA blamed the boom in U.S. shale oil production, slow global growth and a strong dollar. But it added that those low prices would remain under pressure because of supply levels.  Expect actions especially political ones designed to get the market back to contango ASAP.
  • OPEC and Global Oil Politics! I know you are shocked to hear this but these changes in global economic and market fundamentals is upsetting to cartels like OPEC, speculators and bankers trading on commodities, exporters and importers and politicians of all stripes. OPEC oil ministers will be meeting in late November to set oil production targets among the members. As a cartel OPEC wants to control the price of oil. It does so by managing the swing productive capacity available in the market. Saudi Arabia as the largest oil producer can single handedly make up for most oil disruption shortfalls. But other OPEC members often agree to an oil production target and then cheat leaving the Saudi’s balance things out. This was a lot easier before the US shale revolution starting pumping a lot more oil into world markets by displacing OPEC oil imports in the US with US domestic oil production. One of the games of chicken going on today is that the Saudi’s have decided to protect their market share from almost certain cheating by allowing the price to fall thus feeding a market perception of backwardation. Why?  They do this to ‘sweat the excess supply’ out of the market encouraging speculators sitting on floating crude to sell now before prices fall further.  Lower prices also squeeze the economics of new projects reducing the market perception of supply growth.  The Saudi seek to let the market manage the supply growth instead of cutting Saudi production in order to reduce supply and thus raise prices. This denies other OPEC members the ability to cheat—at least at a higher price point.  It also tends to push the market back toward contango or “normal”.  If you are OPEC normal is good—when normal is defined as conditioning customers to expect to pay more for oil in the future.

Put it all together and a rational conclusion might be that the current oil price drop is the result of the normal interplay of the market fundamental and global economic factors described above. If true then prices will stabilize when supply and demand comes back into equilibrium at a given price.

For a cartel like OPEC $80 oil is not good. How long will it last? That depends upon the politics. We have plenty of oil. We are actually awash in it—the question is where competitive global markets will decide the price. It is getting a lot harder for a cartel like OPEC to exercise pricing power given the US oil production growth. If we wanted to assure the best opportunity for competitive global markets, the US would change the law and allow direct US oil exports. Nothing shines more daylight on a cartel than the near term prospect of competitive price market equilibrium.