Strategy & economics
December market review
The law of supply and demand
The price of goods can rarely defy the law of supply and demand: for oil, excess supply over demand is the fundamental reason behind plummeting prices. The sell-off in oil (and commodities generally) has been exacerbated by the end of US quantitative easing, the upswing in the US dollar and a shift in strategy by the Organization of the Petroleum Exporting Countries (OPEC). Unfortunately, there is no buyer of last resort for oil, so it is difficult to create a floor for prices.
Supply – the oil-drenched “black swan”
The difficulties for oil began around five years ago, as the US “shale revolution” entered the production phase. With oil prices stable at $110 per barrel, listed US shale oil producers raised large amounts of capital, while smaller drilling companies piled into the booming sector. As a result, US crude oil production surged from 4 million to just over 9 million barrels per day, the highest since weekly records began in 1983.
Technological advancement has made drilling for oil progressively more efficient, increasing production per unit of investment. Aside from shale oil, non-OPEC supply continues to expand, pushing total oil inventories in advanced economies above their 5-year average. As a result, in the face of heightened geopolitical risks, the oil price did not react as expected. Previously, Saudi Arabia, UAE and Kuwait have adjusted production in response to supply shocks, such as those caused by civil wars in Libya and Syria, Iranian sanctions and continued violence in Iraq. However, they failed to react to the resumption of Libyan oil production since July 2014, setting the stage for a secular downtrend in oil prices.
OPEC’s decision not to cut production on November 27 has prompted the rapid slide in the oil price. We are not surprised by the resistance to cut production, given that OPEC is progressively more dysfunctional as a cartel. The correlation of production across OPEC countries has fallen drastically since the individual country quota system was abandoned in 2011. There is a danger that agreed production cuts are not implemented, given the desire to grow market share, ongoing domestic instability and military funding needs.
The slump in oil prices has already triggered a mini price war within OPEC, with Saudi Arabia and Iran cutting export prices to the US and Asia. While balancing national budgets will be a challenge for weaker OPEC members, stronger countries like Saudi Arabia can afford to wait. The rising financial and political tension within OPEC may actually prompt more production as members hope to compensate for lower prices with higher volumes.
Conspiracy theorists have suggested OPEC intends to crowd out US shale oil producers, by squeezing prices to curb production growth. While WTI crude oil prices at $60 will cause distress for some smaller shale producers, the shale oil breakeven prices for the majority of companies are much lower now the investment phase is completed. While further investment to raise production capacity may be discouraged by the bleaker prospects for the sector, lower oil prices may prompt more near-term production in order to improve cashflow.
With unsupportive fundamentals, a dysfunctional cartel, potentially higher oil production and the lack of a buyer of last resort, weakness in oil prices is likely to persist. However, if OPEC’s strategy works to force some US shale oil producers out of the market, leading to lower production, prices may stabilise in the medium-term. An enduring low oil price will ultimately be painful for all oil exporters.
Demand – when the dragon consumes less…
With a lower level of global growth and the US moving towards energy self-sufficiency, there is no immediate catalyst for a rise in oil prices. Weaker trend growth in emerging markets, in particular China, brings structurally lower marginal demand for oil.
China’s investment-heavy and energy-intensive model of economic growth has seen it account for about two-thirds of the increase in global oil demand over the past decade. We believe China is likely to decelerate to lower, ‘new normal’ growth of 6.5%, as opposed to the levels of 10% and higher seen prior to the financial crisis. The most vulnerable sectors are industrial production and construction investment which are relatively oil intensive. Meanwhile, faster growing sectors, such as services, are significantly less energy consumptive. Also, the Chinese government is keen to reduce pollution and is likely to move toward nuclear energy in the long-term.
The macro backdrop for emerging markets remains difficult: the US is likely to begin tightening in mid-2015. Meanwhile, as global imbalances continue to normalise, the current account surpluses for emerging markets are likely to fall. The previous investment-driven boom in EM is likely to moderate, and slower structural growth is likely to follow.
The US is the only major economy likely to see significantly above trend growth in 2015. However, it is increasingly moving towards energy self-sufficiency and its oil deficit is trending lower. Improving fuel efficiency is also a – less visible – game-changer. On average, automobiles sold in August 2014 could travel 25.8 miles on a gallon of fuel, up 28 percent since 2007, according to the University of Michigan’s Transportation Research Institute. These factors will combine to create lower marginal demand for oil.
The Fed is not always your friend
Commodities, including oil, have ridden the wave of the Federal Reserve’s (Fed) quantitative easing (QE) program. With the conclusion of QE in October, the next stress point for commodities will be the start of the rate hike cycle. Robust non-farm payroll data and higher wage growth suggest that the labour market may tighten quicker than the Fed anticipates, pushing forward the timeline for tightening. The prospect of rate increases in mid-2015 and the resultant boost to the dollar are unambiguously negative for all commodities, including oil.
Lower oil prices – friend or foe of growth?
The 40% slump in oil prices is a tailwind for commodity importing countries and a headwind for commodity exporting countries. Using the Fathom Consulting economic model and the oil price profile suggested by futures contracts, global GDP growth will be given a meaningful boost in 2015 and 2016. The biggest beneficiaries will be consumers whose real spending power will increase. US consumers are likely to enjoy the fastest and most direct fall in oil prices, while currency and other effects will reduce the impact in Europe and China. For emerging market oil importers, such as China and India, the slump in oil prices is potentially very helpful, as lower inflation will lower the hurdle for monetary easing if needed. Lower imported energy bills will be beneficial to other emerging market oil importers with current account deficits, offsetting any hit from Fed tightening.
On the other hand, emerging market oil exporters like Russia and Latin America will struggle. Russia is likely to enter recession in 2015 as the slump in oil prices hits revenues and investment. The plummet in the ruble is likely to drive inflation sharply higher, necessitating tighter monetary policy, despite the economic woes. The same situation applies to Brazil, which is already at or near-recession and confronted with rising inflation. Overall, emerging market commodity exporters will face the biggest potential risks from Fed tightening.
For the Eurozone and Japan, economies struggling with deflationary pressure, the slump in the oil price is helpful in the near term, but may have less beneficial medium-term consequences. The fall in energy bills is positive for consumers and exporters. It has also become much harder for the European Central Bank and Bank of Japan to reach their inflation targets and there will be increased pressure for more outright monetary easing. Less positively, the slump in oil prices may be used by policymakers to resist painful but necessary structural reforms.
This article is issued by Cazenove Capital Management which is a trading name of Schroder & Co. Limited, 12 Moorgate, London, EC2R 6DA. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Issued in the Channel Islands by Cazenove Capital Management which is a trading name of Schroders (C.I.) Limited, licensed and regulated by the Guernsey Financial Services Commission for banking and investment business; and regulated by the Jersey Financial Services Commission.
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All data contained within this document is sourced from Cazenove Capital Management unless otherwise stated