On the collapse of oil
Speculation regarding the price of oil has been the #1 topic of discussion within financial circles over the past few weeks, and for good reason! Since June of this past summer, the price of West Texas Intermediate Crude Oil crashed just over $107 to $53.60. Oil has experienced a monstrous 50% drop in less than six months! A price drop of this magnitude, especially when occurring in a commodity with such a global importance as oil, is intriguing to say the least. Moreover, drops like these leave many market participants asking hard to answer questions such as “What is causing the price of oil to fall so dramatically?” “How come nobody predicted this?” and “How much further will the price of oil fall?” The goal of this article will be to provide reasonable explanations to all of these questions, and more.
Question #1). What is causing the price of oil to fall so dramatically?
There are a wide variety of fundamental reasons used to explain why the price of oil has fallen so relentlessly. A few of these explanations hold more credence than others and we will highlight them now. One justification has to do with America’s own oil boom. The Shale oil production in the United States has reportedly grown by 4 million barrels per day (mbpd) since 2008. This has allowed the U.S. to drastically cut its imports from OPEC which has led to OPEC losing considerable revenue and market share. Recently, the Kingdom of Saudi Arabia’s oil minister Ali-al-Naimi went on record saying “It is not in the interest of OPEC producers to cut their production, whatever the price is.” This is an interesting statement considering almost all of the OPEC countries have estimated break even oil price of $90-$120 to finance their 2014 government budgets. Today’s low oil price is undoubtedly negative for governmental finance of OPEC countries, so why is Saudi Arabia’s oil minister so averse to cutting oil production and limiting the market supply? The easiest to explain this is that 75% of the Shale Oil producers in the U.S. are only viable as long as the price of oil remains elevated above $55 a barrel. This means that almost all the oil drilling operations going on in the Bakken shale wells of North Dakota are flirting with economic disaster. As these U.S. shale producers face the challenge of financial viability, OPEC stands to gain back considerable market share as they are able to meet demand by selling cheap oil and still garner profit. This is the most popular fundamental storyline propagated by the media as it fits into a simple “Supply & Demand” storyline template.
More ominous explanations of why oil is falling have to do with realities that are far less palatable to the general public, but are probably much closer to the underlying truth. It is worth remembering that oil is often referred to as a political commodity. It is the one commodity in which many nations around world have staked their independence, wealth, and subsequent influence upon. These nations have come to be called Petro-States because their prosperity stems from the sale and exportation of petroleum. From this lens, it is easy to see how the price of oil can be the ideal tool of leverage (or economic war) when sorting out diplomatic differences with powerful petro-state nations; i.e. Russia. Switching to a macro-view of recent geopolitical developments, the ongoing economic sanctions against Russia over the annexation of Crimea has led to Russia being left economically isolated and more dependent than ever on its oil export revenues.
The recent drop in oil prices has effectively paralyzed the Russian economy and greatly reduced President Putin’s chips at the bargaining table. The US, EU, and NATO have all displayed immense public displeasure with Russia’s annexation of Crimea. Additionally, Saudi Arabia has been outspoken against Russia’s backing of Syrian President Bashar Al-Assad and is in favor of regime change. The Royal House of Saud views Russia as the only entity preventing Bashar Al-Assad from losing power in Syria. In light of these geopolitical circumstances, it is plausible to conclude that this drop in the price of oil represents a coordinated economic hit against Putin, in order to weaken Russia, and arrive at various desired foreign policy objectives.
Question #2) How come nobody predicted this?
You may remember that a year ago almost all Wall Street analysts had been forecasting a gradual increase in the price of oil for 2014. The prevailing rationale was that oil would be supported by ongoing global demand and that oil prices had reached a “New Normal” above $100 a barrel. The main reason Wall Street analysts could not predict a declining oil price is because to do so would be a complete anathema to the general ongoing “Global Recovery” consensus storyline. After all, how could oil fall this much if there truly was a global recovery inherently involving increasing demand for energy? This price drop caught most people off guard because the growing possibility of global deflation hasn’t yet been conceptualized by most economists and forecasters. So predicting a price drop of this extent and magnitude was not even on their radars.
Questions #3) How much further will the price of oil fall?
From both a technical and fundamental perspective, we at GFC believe oil has considerably further to fall. The current prospects for an OPEC cut in production look extremely grim. Again, here is another quote from Saudi Oil Minister Ali al-Naimi; “As a policy for OPEC, and I convinced OPEC of this, even Mr al-Badri (the OPEC Secretary General) is now convinced, it is not in the interest of OPEC producers to cut their production, whatever the price is, whether it goes to $20, $40, $50, $60, it is irrelevant.” So, there you have it from the world’s most powerful oil man, he fully intends to keep producing a lot of oil and seemingly doesn’t care about effect it might have on price.
From a Technical perspective, we can see that the price of oil broke a significant 5-year trend line in September and has been in a steep decline ever since. This portends an eventual retest of the 2008 low oil made at $33 a barrel after collapsing from $147. It is important to remember the last drastic collapse in oil prices preceded the worst financial crisis since the Great Depression. Does this decline carry similar implications? Time will tell.
This recent decline in oil has occurred with increasing volume and implies that $33 support level will give way new lows into the $20 handle in the future. If that decline unfolds, then it will be a mind blower to most market analysts. Indeed, it could be the beginning of the real “New Normal” landscape in commodities where global demand and subsequently prices remain suppressed for years to come.