Why have oil prices declined so sharply?
As we’ve discussed in the past, commodity prices don’t have a ‘cash flow’ of any sort that allows us to model their intrinsic or ‘fair’ value, as do stocks, bonds or real estate. Instead, supply and demand factors work against each other to find a clearing market price. Economics tells us that either stronger demand or scarcer supplies should cause prices to move higher, while eroding demand or an abundance of supplies has a lowering effect on prices. As complicated as the modeling behind the scenes looks, everything is based on this relationship.
In recessions and periods of slow economic growth, oil demand has tended to remain tempered, but this dynamic has been altered by the growing demand from rapidly developing countries, like China and India, with growth in energy-intensive heavy industry and consumer demand for cars. At the same time, the economies of the U.S. and other developed nations are less reliant on oil than they were several decades ago, due to greater efficiency in usage and availability of other energy sources (like natural gas, which has its own pricing dynamics).
Then comes supply, which despite scares of ‘peak oil’ which have been reported for decades, the world keeps finding more—largely due to improvements in technology, such as deep water ocean drilling, horizontal drilling and ‘fracking,’ which either allow old wells to be reopened and/or opens new areas previously inaccessible due to geologic challenges (ocean depths, oil trapped in shale rock, etc.). This type of oil is naturally more expensive, however, as operating costs rise in accordance to complexity and effort it takes to extract it, but breakeven prices aren’t as prohibitively high as they used to be. The forgotten part of the equation is the Middle East, as the aftermath of the Arab Spring and regional conflicts have resulted in the expansion of capacity from Iraq, Libya and Iran, which has been larger and faster in scope than many have predicted. Large reserves in Iraq, for example, challenge the dominance of Saudi Arabia in the region and have forced the change in OPEC’s thinking from oligopoly pricing to being a bit more flexible in their approach in order to keep themselves relevant.
OPEC’s meeting last week surprised markets by not resulting in any cuts from the current 30 million barrels/day production target—they were widely expected to cut supply in an effort to raise/stabilize world crude prices. Instead, they couldn’t agree on what do, keeping production as is, which ended up pushing the price of crude down to four-year lows. (Note that a serious price war occurred in the 1980s where the Saudis attempted to stem production to solidify prices, but it didn’t work.)
These lower prices have hurt the market prices of energy-related firms, from integrated large cap names like Exxon, to service firms, to even MLPs (which are often marketed as being energy-price agnostic, but tend to be more price-sensitive than many expect). It also affects portions of the high yield market, where energy sector borrowers are naturally dependent on certain oil pricing scenarios to keep revenue- and earnings-to-interest payments ratios in check. If oil revenues drop, these ratios weaken and raise concern for lenders. With many short-term asset movements, this price drop may be an overshoot with chances for some consolidation back towards more ‘expected’ levels, and we all know much markets dislike sudden moves in anything.
But if we stop and take another look, as we’ve spoken about previously, this serves as quite the anti-recessionary force. Recessions have historically occurred due to economic overheating and subsequent ‘tipping points’ back to reality, wars, inflation/interest rate hikes and upward oil price shocks. A downward shock, whether it be in the near-term or even carried through for a prolonged period, offers a powerful stimulative force. According to some analysts, the recent drop in gasoline prices is equivalent to a $75 billion tax cut, and could add as much as a third of a percent to GDP. Already, this has been correlated to sharply higher SUV sales, and other consumer/business behavior can be ‘freed up’ as well.
Before markets get too excited, though, these conditions have a habit of self-correcting from ‘oversold’ levels, at least at the short-term. Saudi oil has about the lowest per-barrel extraction costs in the world (generally under $10/barrel), but profitability for most other areas is obviously dependent on crude’s ultimate market price. As we’ve discussed previously, the ability of oil-producers to balance their budgets is based on this price, which tends to be in $80-100 range. Since oil exports tend to be the primary item these nations rely on for income, there’s some sensitivity to the expenses they incur—a not insignificant amount are transfer payments to keep their populations happy and smooth a few of the more obvious distinctions between extreme wealth and extreme poverty that have evolved over time. Since political power is based on this acceptance of the status quo, this becomes a very large incentive—a poorer populace can ignite anti-establishment and even revolutionary tendencies. Built-up cash in sovereign funds can help temper the pain for a while, perhaps a long while.
Being more work to find, shale and deep-water oil have higher per-barrel breakeven prices. So, for example, if a producer’s shale breakeven is $70/barrel, and if crude prices plunge to $50, many shale projects stop being financially feasible since they’ll be spending more money to get the oil out of the rock than they could ever get back in the marketplace. They may continue to plug along doing this for a while, if it’s expected to be a temporary phenomenon, but not indefinitely. At that point, shale producers would shut down production, so supply could shrink (though dependent on other actions by Middle East producers). At some point, it’s plausible that supply could shrink so much that prices could begin to tighten, then rise again. And the cycle begins anew. If you see a hint of ‘game theory’ or ‘chicken’ in this equation, there certainly is, and there always has been. This scenario is absent a geopolitical shock, such as a terrorist attack, insurgency or other military action involving a major producer, which has traditionally rattled markets and driven prices higher.
Read our Weekly Review for December 1, 2014.
Read the previous Question of the Week for November 10, 2014.