This week the price of West Texas Intermediate (better known as WTI) fell below $45 bbl. Has the price of oil reached the bottom?
In this short article, I will attempt to answer this and other questions related to the price of oil mainly from an investor’s point of view.
The basic principle of supply and demand determines the equilibrium price of oil. However, the market price, or the price being traded in markets, is based on an important variable that is often ignored by the inexperienced investor; expectations. The oil market is currently at the center of a perfect storm of negative expectations.
On the supply side, the American oil industry has stealthily built a fracking industry that has practically led to self-sufficiency in the US. US producers are not permitted to export oil, however, the increase in US oil supply means that the US is able to import less from OPEC and other oil producing regions.
The heavy investment in fracking was only possible since the price of oil remained stable at high prices, thus permitting oil companies to recover their costs. Other oil producing regions also increased production due to the incentive resulting from the high price of oil. The expectations are that US oil producers can survive oil prices at $40.
Traditional oil producing countries like Saudi Arabia, Kuwait and the U.A.E, soon realized that their main source of income was threatened in the long-term. OPEC virtually lost the US market share, and at prices around $100 bbl there was talk of US producers starting to export oil.
In November 2014 OPEC announced that they would not be reducing supply. OPEC is not expected to shift from this stance in the short term. In the meantime Russia, Venezuela and other countries with significant budget constraints cannot afford to reduce production and are reacting by attempting to increase supply where possible; an every penny counts attitude.
On the demand side; technology and environmentalists reacted to the opportunity presented by ultra-high oil prices. The result was five years of massive investment in alternative technology such as solar panels and electric cars. Tesla appears to have made the electric car a reality while energy saving bulbs and solar panels have massively reduced the demand for oil.
An interesting statistic is that while over the past five years the US economy has kept growing, the demand for oil has not. Technology is an important factor that cannot be reversed. Technology is not only making oil extraction cheaper but has also reduced the global dependence on oil.
The most innovative energy saving technology is only coming to the market now. To make matters worse, the global economy is expected to underperform in 2015 leading to lower expected use of energy.
The final player is the US dollar; as oil is traded in US dollars consumer countries will pay more for oil if the dollar is stronger while suppliers will receive more in domestic currency. Thus a stronger dollar reduces the incentive to consume and increases the incentive to supply. As if to make matters worse, a stronger dollar is expected going forward.
Until recently, Saudi Arabia was the only country that trimmed supply when the price of oil weakened.
Has anything similar ever happened before?
In 1985 the price of oil fell 69 percent when Saudi Arabia (sounds familiar) flooded the market with oil. At the time Saudi Arabia had the impression that OPEC members were cheating by undercutting the Saudis and supplying oil cheaply outside of OPEC. Saudi Arabia maintained its stance for five years.
How far down can the price of oil go?
If the Saudis are out to kill the competition, then what we have seen are only the warning shots. Saudi Arabia extracts oil at $5 bbl, ‘Frackers’ are perceived to break-even between $40 and $50. In economic talk; till now Saudi action has resulted in movement along the supply curve, but it will take a massive shift in the curve for the Saudis to achieve their goal, and that will mean prolonged periods of oil below $40, until the high cost producers pack and vow never to return.
Disclaimer:
This article was issued by Antoine Briffa, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt . The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.