I’ve had a few folks recently ask about the drop in oil prices, and I suspect some of you may have questions as well. I thought I’d pass on my current thoughts.
Right now, the volatility and speed of oil’s pullback has been amazing. However, this is not unusual for commodities. For example, serious coffee drinkers will be able to talk about how coffee bean prices spiked over 20% in the first few months of 2014 following concerns about supply. Keep in mind that commodities do not have a quarterly reporting season. They don’t have cash flows, they can’t declare or pay dividends, and there isn’t a new “iOil Barrel Six Plus with Retina display” release coming out.
So unlike stocks, commodity traders spend a far greater time looking at charts and chart patterns trying to figure out where the price might be headed. The recent selloff in oil broke through some “Fibonacci” support lines, which is a fancy way of saying people freaked out when it broke $82, and then $72. Next up would be a break below $62, which is occurring as I write this.
OK, so what’s going on? And what may happen? Here’s a list, while it’s none of these things individually, I believe it’s a combination of all these factors:
• During Thanksgiving week, oil had huge swings in price, mostly due to the OPEC meeting. The timing of the OPEC meeting was ideal for major moves since the US markets were closed, or holiday-staffed. Those sharp moves created panic and fear.
• OPEC refused to cut production and the price of oil dropped. Heading into the meeting, the outlook was split between a cut and no cut in oil production by OPEC. Without a clear consensus view, volatility was a fore gone conclusion.
• US production is at THE HIGHEST RATE PER DAY SINCE 1986. This is happening at an amazing rate of change too, and as of right now there doesn’t appear to be any stalling. Since 2008, production has increased at an annual rate of almost 9%. In fact, we’ve almost doubled production per day, from the early 2000’s. Look at the chart from the US Energy Information Administration:
• We have a weaker global economy. Forecasts for total energy consumption around the globe are coming in below expectations, as the Eurozone and China continue to struggle to find economic growth. There’s chatter that next year may be weaker than currently expected as well, so demand for oil is currently moving in the wrong direction to support high prices.
• Libya, Iran and Iraq have all increased production at a faster rate than originally expected. Libya alone has gone from 200k barrels a day in late 2013, to almost 800k a day now. These may seem like insignificant amounts globally, but it’s all about what’s happening on the margins. This rapid move back online was NOT expected. If these growth rates were to continue, supply will be higher than originally thought.
• Citibank estimates that the world is producing 700k MORE barrels a day than the world currently needs. That sort of glut doesn’t evaporate overnight. Economics 101: if the supply of something is growing, while the demand is weakening, typically price has only one way to go, DOWN!
• There’s a LOT of debate around whether OPEC has given up, or plain lost its “control” of the oil market. They still produce 40% of the oil globally, but there was always a belief embedded in projects and production that there is an “OPEC PUT” on prices, meaning that they would defend a higher price to support the government’s in OPEC. Without a clear reason, there are a lot of theories as to why they didn’t cut production.
The most likely explanation is that they are losing market share AND they believe they have some leverage. The cost to get a barrel of oil out of the ground in the US is far greater than it is in the Middle East (though there’s debate about how much it really costs here in the US; some think it’s far lower than reported for places like the Dakotas). Yes, OPEC nations are heavily dependent on the cash flow that higher oil prices support, but they appear to be willing to play chicken with the US producers to regain market share.
So where does all this lead?
Well, for one, inflation should be contained and for much longer than expected. US Consumers are benefitting from a tremendous “tax break” and in turn this could keep wage inflation expectations at bay. Lower inflation could allow the Fed to delay a change in policy for longer than originally expected. Manufacturing and other sectors of the economy that are dependent on oil as a cost input should benefit (i.e., the transportation sector). Retailers and restaurants should also benefit, and we have seen data points over the last months that seem to show that the savings at the pump are being spent in those places. Automobile sales should also benefit. From everything that I’ve read and analyzed, the net effect on the US economy is positive, even if the energy sector is struggling. We believe that lower oil prices should be a tailwind for the US Economy, and that should be supportive for higher equity prices overall.
Derek Amey serves as Managing Director and Portfolio Manager at StrategicPoint Investment Advisors in Providence and East Greenwich. You can e-mail him at damey@strategicpoint.com.
The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Derek’s opinions and comments expressed on this site are his own and may not accurately reflect those of the firm. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.