Having averaged around $108 per barrel in the first half of 2014, hitting a high of $115 per barrel in June, the price of Brent Oil has slumped in recent months to around $85 dollars per barrel currently. Here, we look at the fundamental reasons why and some of the implications for the stock market and the macroeconomy.
Economics 1-0-1 — supply & demand matter
In recent years, the supply of oil has been steadily rising. The “Shale Revolution” in the US has been significant with substantial new supplies of natural gas and ‘tight oil’ coming on stream, drastically reducing US dependence on imported energy. Buoyed by the high price of oil which has improved the economics of shale, US companies have been ramping up production, with 1.3m barrels per day being added so far this year1.
Elsewhere, growth in output from Iraq, Libya and Nigeria, plus a steady production performance from Saudi Arabia and other Gulf producers, has led to this steady but meaningful increase in oil supply.
At the same time, however, the global economy has started to disappoint what we have long believed to be overly optimistic growth expectations. This is already having a noticeable impact on crude oil demand, particularly from Europe and Japan, but also in China, where oil demand growth has slowed dramatically in recent months. The overall demand picture looks poor and continues to deteriorate.
So the oil market looks like it has been flooded with new supply at a time when demand is faltering – a dangerous economic cocktail which inevitably means lower prices. But shouldn’t the market have seen this coming and adjusted the price more gradually? We suspect it probably did see it coming but the oil price is of course particularly prone to being influenced by other factors such as geo-political risk. Tensions in the Middle East and Russia, both key oil producing regions, may have held the price higher than fundamentals justified for much of the spring and summer but ultimately, fundamentals have a habit of reasserting themselves – in commodity markets as well as stock markets.
The timing of the most recent leg down in the oil price is also to do with Saudi Arabia’s historic role as ‘swing producer’ in the oil market. Many commodity market specialists had expected the Saudi’s to respond to the lower oil price by cutting production to maintain the market equilibrium at a higher price. It’s refusal to do so has alarmed the market, but can be explained by the high cost of production embedded in the US Shale industry – about a third of US shale oil production is uneconomic at $80 per barrel2, so the Saudi’s refusal to ‘swing’ is likely to force others to do so.
Although a supply-side response seems inevitable, as the highest cost producers are priced out of the market, oil prices may continue to be influenced by faltering demand. As things currently stand, however, Goldman Sachs estimates suggest that supply will exceed demand through to at least 2016.