What to Make of Lower Oil Prices? Merry Christmas!

Lower Demand and Higher Libyan Supply

SOURCE: US EIA

As I write this on October 13, 2014, the Brent crude oil price is $88per barrel or about 23% lower than its $115 year-to-date peak on June 19. For 13 straight months until July 2014 monthly Brent spot prices traded from $107 to $112 per barrel according to the US Energy information Administration (EIA).

As oil prices declined  below $100 per barrel the herd mentality has been of display big time as the price of oil dropped and the herd started running faster—the question is whether they are running for the cliff like lemmings to the sea or running to buy up the bargains—oil at sale prices!

Then the NYSE Dow Jones average gave back all its gains for the year as the market tumbled.  The combination of falling oil prices AND a falling stock market is increasing the size of the herd. Should we sell our stocks or hang tough hoping the market will bounce back is the question everyone is asking?

You’ve seen the press reports about an overpriced stock market driven to unrealistic highs from Federal Reserve policies keeping interest rates so low that there is no place for money to go except the stock market. Pundits spin their stories about the failings of the Obama Presidency, foreign policy in disarray, ebola screening mismanagement and other issues pointing fingers at all incumbents.

You’ve heard the fundamentals by now driving this story—abundant oil supplies around the world—so much oil that not even the latest ISIS attack can keep the price from falling. Looking at the facts rather than the hyperbole, the long bull market was overdue for a correction. But while we expected a stock market correction, we didn’t see an oil price correction coming.

Is that what is going on?

Continued E&P growth in the United States from the shale revolution with a return of Libyan oil production and Iraqi oil production to market means we are awash in oil.  Meanwhile, sky high E&P costs driven up by high demand for oil field services, rigs and expertise leave producers wondering how much more to spend when global demand is weak from fears that Europe may slide back into recession, China growth may be softening from fears a bubble is about the burst, and the United States is limping along waiting out the election this year and 2016 where surly voters frustrated that the country is going in the wrong direction according to the polls will sweep out the party in power and hope things get better.

Not all this production growth has been paid for with cash in hand, some—maybe too much—has been produced on leverage.  It does not take a Texas oilman to realize that the combination of high debt leverage in a falling oil price market is not a way to do ‘bidness’!  So what is happening?

We keep forgetting that the oil and gas business works on boom and bust cycles. There is bound to be trouble when we project today’s prices forward no matter whether prices are high or low.  The truth is volatility at work in the market today is the normal result of our global search for equilibrium—that place that balances supply and demand, where prices are reasonably related to the marginal cost of the next unit produced, where even politicians act rationally and market direction is predictable. Quit laughing. There is such a place and we will find it again probably sooner than you think.

When?

• When the insatiable production demand for rigs, leveraged financing and skilled workers comes into balance with the reasonable market expectations for economic growth and real oil demand.
• When speculators who leveraged themselves to the max to drill that next well are humbled by a capital call that persuades others that flying high like Icarus will get you burned.
• And when resource nationalists are forced to pay more attention to business than their geopolitical mischief making and their trouble making acolytes run out of money.

And while the oil industry is crying about falling oil prices, consumers are cheering. Finally, we’re getting a little relief at the pump. So how long will this volatility in the market last? About as long as it takes a politician asking for your vote to claim credit for lower gasoline prices. Sweating the excess out of markets is what corrections do well.

So go do your early Christmas shopping, put the gifts on layaway—and pay them off with gasoline savings before prices go up or Santa arrives whichever is first.