That’s Oil She Wrote Folks!

Markets are a little shell-shocked as oil prices continue to drop due to a combination of oversupply and sluggish demand.

There are a number of different classifications for crude oil, including the Brent and West Texas Intermediate (WTI).

Brent Crude oil reached a peak of $115 a barrel earlier this summer before plummeting to a price of $82, a nearly 30% drop.

WTI Crude oil similarly tumbled, from a high of $105 to $79, a 20% drop.

No one is really sure where oil is headed, and analysts are rushing to build a consensus.

There’s too much oil!

Oil is leaking out from everywhere!

The U.S. is experiencing an oil bonanza, displacing Saudi Arabia to become the world’s largest oil producer.  It now supplies an average of 12.5 million barrels a day (mb/d), an increase of about 1.5 million barrels from its daily average in 2013.

Source: OPEC Monthly Oil Report, October 2014
Source: OPEC Monthly Oil Report, October 2014

Both Iraq and Libya have increased production as well, with the former Qadaffi-run state being a particularly interesting case. Libya was supplying some 800 thousand barrels a day (tb/d) in September, an increase of 250 tb/d from just a month previously!

Source: The Economist
Source: The Economist

Libyan oil production may be running hot, but they are still only producing around half of what they were putting out in early 2013.

Meanwhile, Russia is keeping its output near record highs despite an environment of international sanctions and low prices. The former Soviet nation is currently producing about 10.6 mb/d.

Source: OPEC Monthly Oil Report, October 2014
Source: OPEC Monthly Oil Report, October 2014

As you can see in the figure above; both world oil supply and OPEC oil supply have been steadily rising since March.

Weak Oil Demand Isn’t Helping Matters

The plunging drop in oil prices is driven by both supply and demand factors. The world economy is hitting a soft patch, the euro area is dragging its feet through the mud and there’s less demand for oil worldwide. In the U.S. and Japan, two of the top five importers of oil, demand has decreased. According to OPEC, Japanese oil demand has been declining for five consecutive months – mainly due to a weakening economy.

The silver lining is that lower oil prices will stimulate growth, especially for net oil importers where lower prices act as a sort of tax cut.

For example, China is the second largest net importer of oil, they buy more oil than they sell, and a 20% discount on their energy bill works out to around $60 billion!

Consumers stand to benefit as well, as lower oil prices mean lower prices at the pump when it comes time to fill up your SUV.

That also leaves more money in the pockets of consumers to spend on other things, which serves to stimulate the economy as well.

While some stand to gain, others lose out.

In many oil producing nations, the energy industry is the breadwinner. The profits from selling oil props these countries up and in many cases, allows them to keep going.

Countries like Iran, Venezuela, and Libya need oil at prices above $100 a barrel to finance their government spending plans. If a country does not have a lot of money saved up in the form of reserves then a climate of low prices can really hurt them in the short-term.

On the other hand, a country like Saudi Arabia has a surplus of money which cushions them against low oil prices.  This allows them to ride out an environment of low prices in relative comfort.

The Saudis don’t seem content to ride it out though. Their actions, in cutting production by 400,000 barrels a day and increasing prices to Asian consumers, indicates that they are actively trying to exert upward pressure on prices.

Where do we go from here?

The last thing to consider is that many hedge fund managers are cutting their positions in oil. They went in for the long haul thinking oil prices would continue to go up and then start dumping their holdings as oil dipped below $90 a barrel. These actions will serve to depress prices further.

The investment bank Goldman Sachs has forecasted that oil prices have further to fall, reaching $70 a barrel by next year before rebounding to $100 in 2016 as supply and demand forces work themselves out.

 

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