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Oil prices have further to fall as Great Unwinding continues

Economic growth
By Paul Hodges on 17-Oct-2014

Brent Oct14Oil prices are highly likely to fall further, not rebound, over the next few months.  That is the blog’s conclusion to its 3-part analysis of likely developments in oil markets.

Having looked at the outlook for oil supply and demand over the past 2 days, today’s post looks at the key question of ‘what does this mean for oil prices’?

The key is that the Great Unwinding means markets will return to setting prices by reference to supply and demand.

This will be a major change.  As the above chart shows, policymakers’ stimulus programmes have instead meant that oil prices (red line) have been at levels which always led to recessions (pink column) in the past.  The difference this time has been the flood of low-cost money from the central banks, and China’s massive stimulus programme.

These artificially boosted prices, and also demand to some extent.  But now their impact is reducing as the Great Unwinding takes place.  Thus it is becoming clear that:

Those hoping that prices will rise are essentially betting on a geo-political upset to occur.  One obvious risk is that Russia resumes its military adventures in Eastern or Central Europe.  Its economy is highly dependent on oil and gas exports.  So it could decide to threaten invasion, or cut off gas supplies to the Ukraine to force global prices higher.

In the absence of Russian or other geo-political intervention, Saudi Arabia will likely be key to the future direction.  Its priority must be to secure its US sales, even if this means head-to-head competition with N American production.  Otherwise, as discussed on Wednesday, it risks losing its defence alliance with America.

As fellow-blogger John Richardson has noted, the new US production probably has break-even costs around $40/bbl, so will be hard to shutdown.  But Canada’s oil sands could be vulnerable to a prolonged period of prices below $50/bbl.

Thus as Reuters reported last week, the Saudi strategy is becoming clear:

Brent crude oil fell to its lowest since 2010 on Friday, dropping below $90 a barrel as Saudi Arabia said it upped production last month, increasing speculation of an OPEC price war.  Fast-rising oil output in North America and tepid economic growth had raised expectations the Organization of the Petroleum Exporting Countries will cut output when it meets in November to stem a near 25 percent price slide since June.

“But on Friday Saudi Arabia said it had raised its oil production by 100,000 barrels per day in September, raising doubts the world’s top exporter will be prepared to take unilateral action.”

In reality, Saudi has very few strategic options.  Readers with long memories will recall that it tried playing the role of ‘swing supplier’ in 1980-1985.  It cut production from 10.2md to 3.6mbd to support prices.  But, of course, the rest of OPEC simply increased their output to take advantage of Saudi’s lost volume.

Saudi is unlikely to make the same mistake twice.  And they can afford to take the pain, as prudent management means the Kingdom’s gross budget deficit is only 2.7% of GDP.

Investors and companies who expect a ‘business as usual’ scenario are thus in danger of missing the key issue.  They need to prepare for more volatility and further price falls.  One reason is simply that a key impact of today’s falling prices is to reduce apparent demand even further:

  • Companies’ first reaction has been to reduce inventories to minimum levels all down the various value chains
  • Most have also stopped trying “buy on the dips” as the result till now has instead been to “catch a falling knife”
  • Banks are also becoming nervous, calling in loans as the value of their collateral reduces with the oil price

Plus, of course, there is the potential impact from forced sales of all the so-called ‘contango oil’ stored in tanks and ships around the world:

  • Traders have taken advantage of the US Federal Reserve’ low-cost lending policy to store up to 50 million barrels
  • As prices fall, this gamble on higher prices is not looking so clever
  • So we can expect this to lead to panic sales, as people try to clear their positions.

It would have been much better if central banks had left well alone in 2009, and allowed markets to do what they do best, namely balance supply and demand.  But they didn’t.

Instead they chose to try and boost growth by boosting asset prices in financial markets.  In turn, these distorted price signals led oil producers and their major customers to over-invest in new capacity.

Now as the blog has long feared, it will be those of us living in the real world outside financial markets who will have to pick up the pieces from their mistake.