Oil Prices: Lower for Longer?

02/10/2015

Stephen Walker

From our guest blogger, Stephen Walker, CFA - Investment Strategist.

Oil Prices: Lower for Longer?

In recent months there has been no shortage of headlines bemoaning the significant declines in commodity prices.

But there appears to be a widening gap between the reality and the headlines.

There are a variety of forces at work - some of which are working in tandem, thus exaggerating the impact of the decline in commodity prices.

The decline has important implications for investors but it also has an impact on the world of geopolitics and the desire of major economies to project ‘soft’ power internationally.

The key force to be discussed here is the surge in US energy output that is helping to depress the oil price.

Commodity prices explained

Commodity prices are determined by the twin forces of supply and demand, which in turn vary according to the underlying price of the commodity.

Appetite to supply or demand for a particular commodity can be highly price sensitive (or not) and this can serve to accelerate or slow down the pace at which the market returns to equilibrium.

For many years, the Organisation of the Petroleum Exporting Countries (OPEC) has had a highly influential role in the setting of the oil price: they were able, somewhat surprisingly, to ‘encourage’ a price that suited the governments of the various OPEC members. This served to ‘divorce’ the oil price from the ‘breakeven’ price needed to incentivise sufficient supply to meet demand.

The surge in US oil production driven by the shale revolution has grabbed many of the headlines. Nonetheless, OPEC remains the single largest oil producer. And yet, its ability to influence prices has diminished.

Why has OPEC’s power lessened?

1.       Firstly, OPEC is nominally a cartel but recently has not behaved as such.  

In order to deal with an oversupplied market, OPEC has shied away from slashing production, thereby prioritising market share over price.

The market has moved beyond the conviction that OPEC is a magical source of price-setting power and economics have kicked in. OPEC believes that it can outlast US shale producers and see prices rise again.

But they may not be able to put the genie back in the bottle.

2.       US shale has become the marginal source of supply in the oil market.

Previously, OPEC adjusted supply up or down according to their desire. Now it is US shale supply  that will respond most to higher/lower prices.

The collapse in the oil price has driven a dramatic reduction in planned capital expenditure that, given the shorter producing life of shale wells, may translate into declining production in 12-18 months time.

However, the changed industry backdrop has driven sharp drops in the cost of drilling/operating a well whilst the straitened environment is providing fresh impetus to improving technological capabilities.

This means the price at which various shale wells are profitable is coming down all the time.

For large oil deposits it is often expensive to bring production online but once that has been done, operating costs are very low. With shale, it is more expensive to operate but easy to shut down and then bring on-line. Any drop in shale oil production that revives the oil price could therefore increase production which then pushes prices back down, and so on.

This would imply that the future equilibrium oil price will be materially lower than the $100 or so of recent years; $50-60 is probably more like it.

Energy independence in the US

Whilst President Obama has largely sought to disengage America from the rest of the world, both militarily and diplomatically, his ability to do so has been helped greatly by the move of the US towards energy independence.

Although the powerful pro-Israel lobby has long influenced policymaking in Washington, American involvement in the Middle East has typically centred on financial interests and, in particular, security of oil supply. That imperative is now very much diminished, and although American efforts in the Middle East have had mixed success, their increased disinterest is leaving a vacuum that Putin’s Russia is seeking to fill.

Lower oil prices may leave the energy sector and some oil-dependent countries in a sorry state but they reverse the prior implied subsidy by (largely speaking) the major developed economies, who are net importers.

A boost to China’s economy

Furthermore, the price drop provides a much needed boost to the global economy as well as to China.

Over the last 5 years or so, China’s voracious appetite for natural resources led it to be increasingly on the front foot in Africa. With the pivot towards a more consumer-driven economy this becomes less necessary.

Indeed, Russia may now be trying to compensate for its diminished economic power by flexing its diplomatic and military muscles.

Conclusion

A tumbling oil price is arguably both a symptom and a contributory factor to the state of geopolitical and economic flux that the world finds itself in. It will be interesting to see whether the next 12 months can live up to the unexpected events of the last year.