A Window On Crude Oil Prices

Driven by a massive and lingering imbalance ― excess of supply over demand ― global crude oil prices have fallen by more than 60% since mid-2014 to multi-year lows, and the impact has been significant. Producing companies have deferred or even cancelled development projects worth billions of dollars and industry job losses are estimated to be about 200,000 with more expected. Once-bustling oil patch communities have become near-ghost towns. Corporate profits among the oil majors slumped as much as 64% year-on-year; some upstream companies have filed for bankruptcy and both banks and investors that are exposed to them have been impacted.

Going forward, certain critical issues will likely define global oil prices.

Fundamentals

The International Energy Agency, IEA, recently reported a massive global crude oil inventory of about 3 billion barrels. Estimates of the current global crude oil imbalance range from 1.5 million barrels per day (MMbpd) to 3 MMbpd. According to the Organization of the Petroleum Exporting Countries, OPEC, that value is about 2 MMbpd. With increasing supply and a sluggish growth in demand, there is at present, no real indication that the widening imbalance will be reversed any time soon. Global crude oil prices therefore, baring incidental effects, will likely remain low in the near term.

Russia, for example, set a post-Soviet production record of 10.825 MMbpd just last month even as her exports for 2015 rose to 5.25 MMbpd, World Oil reports. Saudi Arabia, which has been fighting for market share has been flaring the oil taps. While a number of U.S. shale oil producers have “closed shop”, operators of oil-rich or “sweet” acreages have employed higher efficiency techniques to maintain output. In addition, U.S. “stripper” well operators, which produce as little as 10 bpd ― but constitute about 10% of U.S. production ― have also reconfigured operations to bolster output; and with the expected lifting of sanctions on Iran, the country is set to increase output by 1 MMbpd within six months, adding to the massive supply overhang. Even the United Kingdom’s oil and gas production increased for the first time in 15 years last year.

There have been concerns about a slowdown in global manufacturing, which would in turn dampen oil demand. Those fears were recently confirmed. The Institute for Supply Management, ISM, reported that factory activity in the U.S. shrank unexpectedly in December. China, a major energy-importing country is the world’s second-largest economy and has been a driver for global crude oil demand. Analysts believe that after the initial rapid growth, the country is easing into a developed economy and therefore will now be growing at a much slower rate. Such is China’s effect on the global economy that the recent release of the country’s economic data sent global stocks plummeting on fears of an economic downturn.

Incidentals

Issues other than supply and demand will likely bear on oil prices in the near term and regional tensions are one of the more critical ones. The Middle East region, in spite of the US shale boom, holds a strategic position in global crude oil supply and therefore prices. According to Energy Information Administration, the region accounted for about 31% and 49% of global crude oil supply and reserves respectively in 2014; but more importantly, it can produce the commodity at much lower cost than any other region and that has been the driving force behind the Saudis’ strident quest for increased market share.

Prior to the streaming of the US shale oil, the concern was about a price spike arising from any disruption in supply from the region. At present, many of those shale producers would probably welcome a supply cutback from Saudi Arabia, where increased supply and at much lower cost has sent many higher-cost producers into hibernation or instant death. The region ― home of the Strait of Hormuz, which is considered one of the most strategic of straits in the world ― has seen some considerable flashpoints in recent years, of which the “Arab Spring” was one; either way, any disruption in the region’s oil supply is bound to affect global oil prices.

The current item on the watch list derives from ideological and other differences between two of the region’s highest-volume producers, Saudi Arabia and Iran. The differences found expression in the inability of OPEC to set production quotas during the last meeting, and that caused a further fall in oil prices. Tensions have since been escalated by the Saudi government’s execution of a Shiite cleric just a few days ago and the reported downing of a ballistic missile targeted at the Saudi petrochemicals and oil terminal site of Jizan.

Some analysts hold that these countries are already locked in proxy wars in places such as Yemen, Iraq and Syria; a major escalation, possibly with the U.S. and Russia taking sides, would therefore bear significant effects on global crude oil prices. With the recent severing of diplomatic ties between them, it is unlikely those inveterate differences will be resolved any time soon; however, it remains to be seen if the painful reality of falling prices will force the parties to a conciliation table.

The strength of the U.S. dollar as well as the current weather pattern are other incidental issues. With a strengthening dollar, holders of the (dollar-denominated) commodity will find it more expensive while the rather mild start to the winter season, in concert with increasing output will likely foist bearish sentiments on oil prices over the next few months.

Speculation

Market speculators often drive the prices of commodities such as crude oil and the availability of “cheap” money often provides added fuel. The driving force can be even in spite of market fundamentals. During the financial crises and oil price volatility of 2008 for example, oil prices spiked to a record high while the market was well-supplied. As described then by former Director of the International Petroleum Exchange, Chris Cook:

“…the principal cause of the financial crises and of the volatility are one and the same – to wit, the ‘leverage’ or ‘gearing’ derived in the former case by deficit-based credit creation by banks, and in the latter case by both bank credit creation and forward/futures contracts”.

The impact of speculation can range from minor price movements to a major shock. Just a fortnight ago, oil prices again fell on traders’ speculation that the fight for market share among the largest Middle East producers will exacerbate the current supply overhang. The expectation by some traders, that the spate of canceled or deferred oil development projects will lead to the inability of future supply to meet a demand rebound, is a potential driver for a major oil price shock. Any indication of a sustained demand rebound would then be the speculators’ trigger.