In less than 2 months we have seen the price of a oil barrel falling by more than 32%, suffering its biggest drop since the raw materials crisis in 2015. Is this drop justified?
Energy long-term investors are suffering a difficult period lately, since market experts have been talking for several months about an oil price of 100 dollars as an unavoidable fact even if, looking at recent events, it seems less likely. What are the facts that have pushed oil prices down since the beginning of October? Let’s explain it in detail.
Production increased by OPEC+ countries
During the summer, Arabia and Russia, the two main oil producers in the OPEC+ group, which had been restricting production since 2017, opened taps increasing production by more than 1 mbpd, with the aim of alleviating consumer concerns and in response to Trump’s request.
While OPEC’s influence is reduced by an increased production in the USA, the cartel remains important, mainly due to Arabia’s surplus capacity to balance supply and demand and also to the market’s increased credibility towards the cartel, due to high compliance with the latest agreements.
However, OPEC scheduled to meet in Vienna next month where it could consider a change in the current strategy.
U.S. shale production increase.
The United States, thanks to the shale boom, has overtaken the Saudis as the world’s largest oil producer and expects to reach 12 mbpd by 2019, meaning it could become a net oil exporter for the first time in 75 years.
USA – Iran sanctions
The market did not foresee that Trump might take a position on the matter, on the one hand, by granting exemptions to eight Iranian crude oil buyers to make sure that the market was well supplied even harming the Iranian economy, which went into recession.
In fact, Japan and South Korea, which had virtually eliminated Iran’s imports, plan to resume oil purchases from Iran again from January, which has lowered the impact of the penalty and has been picked up by the financial markets.
USA – Elections
The United States has always been one of the largest oil producers in the world, as it is in terms of consumption, so any variation in crude oil prices will influence the country’s economy. High oil prices hurt energy-intensive consumers and manufacturers. On the other hand low prices, even if they promote transportation, threaten investment in oil and gas and in the future the viability of the oil industry.
So White House economists estimate that a moderate price decline, with the consequent boost to consumption, could offset the impact on oil sector investment.
Hedge funds sales
Suddenly there has been a different interpretation to the uncertainty of the supply in the crude oil market. If in the last few months the crude oil was under pressure from the production difficulties in Venezuela and the sanctions on Iran’s production, now the market is worried about supply excess and this has led to a change in financial positions.
The hedge funds eliminate the bullish bets that had accumulated since the second half of 2017. The last two months have seen the largest liquidation of long-term positions not seen since 2013. Long positions are now at their lowest level since January 2016, a period of time that coincided with the lowest part of the oil market cycle.
The following graph shows how prices have moved in relation to raw materials demand.
Global demand outlook
According to the International Energy Agency, global demand growth levels will be maintained in 2018 and 2019 at 1.3 mbpd and 1.4 mbpd respectively, but it has lowered its estimate of demand growth for non-OECD countries (the engine of expansion of world crude oil consumption). This increases the uncertainty about the outlook for the world economy in 2019, which until now was expected to be stable and growing.
Prices back on the rise?
The largest investment funds estimate the Brent as a range between 65-85 dollars, but there are also arguments that could bring prices to 100 dollars.
Refineries are increasing production after a period of intense maintenance in recent months, which increases demand for oil. On the other hand Trump, after mid-term elections, could change his pro-low price stance to support tougher sanctions on Iran again. It is also up to them to resolve the trade conflict with China, another factor that would increase demand.
Moreover, it remains to be seen how OPEC will pronounce on this situation. The organisation will meet next December 6th in Vienna to discuss whether to cut production or not. Let us remember that most of the countries that are part of the organization do not find profitable to sell oil below 70 dollars a barrel and they will do everything in their power to prevent it. The Energy Minister of Arabia talks about concrete figures: the cut could be above 1 mbpd in order to avoid a scenario of supply excess similar to the one in 2014, thus maintaining the current quota cut.
The lower demand, if the prospects of a slowdown in the economy are effectively fulfilled, would justify OPEC’s cutting movement. The group produces about a third of the world’s crude oil supply, so, although it is becoming less and less important, it continues to be a key factor in the evolution of prices.
However, Russia’s participation is key for the cut agreement to take place and they have already expressed their reluctance to push prices again. Therefore, depending on the evolution of the aforementioned events and those that may occur, we will see where a sector as strategic at a global level as that of oil is moving.