The market conditions that have driven the price or crude oil down over 50 percent in seven months remain intact. The combination of burgeoning supply, competition for market share and political advantage between oil producers, a slowdown in world economic growth of unknown depth and duration and a surging U.S. Dollar have been responsible for the sharpest fall in crude price since the financial crisis and recession.
Absent a substantial deterioration in world economic activity oil prices will probably not incur a large decline from current levels. But neither will they return to the $97 average price of the 2 1/2 years before last June. Unlike the extreme speculative ascent, fall and gradual recovery in prices around the 2008 events, this slide is firmly grounded in macro–economic trends, though political developments in the Middle East and elsewhere could always upend current predictions.
The North American shale revolution has been building for half a decade but its production reached critical mass and market notice last year as domestic U.S. production surpassed levels last seen a generation ago. United States crude output crossed the eight million barrels a day threshold in January 2014. The last time the domestic production was above eight million barrels was November 1988. In the following fourteen months production added another 1.3 million barrels to 9.285 million in the week ending February 20th, a 40 year record for American output.
Despite the steep fall in crude prices since the summer and the equally rapid drop in the U.S. domestic rig count from 1609 last October to 1019 in February, American production is not expected to be affected.
For oil production companies the bulk of the investment is before production. Once a rig is producing its additional operating expense is small and its pumped crude, whatever the sale price, is income. Oil exploration and drilling companies have cut back substantially on investment and the search for new wells, but the current rigs have continued to produce. Any drop in U.S. production, particularly in the shale fields will come as exhausted rigs are taken offline, rather than from shutting down active wells, and that is months or more away. North American shale producers have every economic reason to maintain production as long and voluminously as they can.
OPEC, Russia and other large oil producers have been unable or unwilling to reduce production in an effort to restrict supply. It is debatable whether such a move would have succeeded with North American shale producers waiting in the wings. But at any rate it was not tried despite requests from Iran and other OPEC members. Saudi Arabia, the world’s largest marginal producer, has chosen a policy of maintaining market share rather than price support.
The Kingdom has economic and political logic behind its decision-- market share is hard to regain once lost and the economy of its chief regional competitor, Iran, is more vulnerable to prolonged weakness in oil revenue than is Saudi. In addition, a long bout of crude prices below $75 may inhibit competition from U.S. and Canadian shale producers whose production and exploration costs are considerably higher than those of the Middle East. OPEC supplies roughly a third of global oil production.
Global supply and demand figures from the fourth quarter show a surplus with production at 94.34 million barrels a day and demand at 93.53 million barrels, according to the International Energy Agency (IEA).
Demand was steady at 92.44 million barrels a day in January and it is predicted by the IEA to average 92.55 million barrels for the first quarter. Supply averaged 94.1 million barrels in January.
The 2015 demand forecast from the IEA calls for a slight decline to an average of 93.37 million barrels a day for the year. With U.S. production expected to continue to rise this year and next, according to the U.S. Energy Information Agency, and OPEC and other producers maintaining current production levels there will be little supply pressure affecting prices through at least the end of the second quarter.
U.S. crude oil inventories rose 8.427 million barrels in the week ending February 29th, the seventh gain in a row, underlining the oversupply affecting global markets.
If the supply side is exhibiting symptoms of continued overproduction, the risk on the demand side is for a further slackening of economic growth in the major oil consumption markets.
Despite the best United States economic growth rate in a decade in the third quarter of last year at 5.0 percent annualized, GDP dropped by almost half to 2.6 percent in the last three months of the year and is projected to be revised to 2.0% on Friday. The Federal Reserve central tendency for GDP in 2015 has seen steady erosion over the past year. In March 2014 the Fed predicted 3.0 to 3.4, in September 3.0 to 3.2 and in December 2.6 to 3.0. Many private analysts now expect U.S. economic growth to be closer to 2.2 to 2.7 percent, on par with the 2.4 percent average the past three years.
Economic growth in the Eurozone is moribund. Quarter on quarter expansion averaged just 0.225 percent in 2014 and annual growth was only 0.9 percent for the year. The European Central Bank is hoping to fight off deflation and spur economic growth with its proposed sovereign debt purchase plan but the possibility that quantitative easing will return the continent to robust growth is slim.
In Asia, China is managing a property bubble, an overbuilt manufacturing sector and attempting to move the economy from a reliance on exports to greater balance on domestic consumption. In the process annual GDP growth has fallen to 7.3 percent in the fourth quarter of 2014 and measured 7.38 percent for the year, the lowest in over a decade.
In Japan the policies of Prime Minister Shinzo Abe has been unable to generate steady economic progress despite a more than 50 percent devaluation of the Japanese Yen in the past two and a half years. The economy returned to growth in the fourth quarter of 2014, registering a 2.2 percent annualized expansion but that followed two quarters of recession.
The International Monetary Fund (IMF) has reduced its projection for global economic growth in 2015 from 3.8 percent in the October forecast, to 3.5 percent in the January estimate. Of all the advanced economies, including China, only the United States, which the IMF optimistically lists at 3.6 percent for the year, saw its estimate increase.
The strength of the U.S. Dollar has added to the burden on crude prices. The greenback has soared 20 percent against the euro since last summer and 18 percent against the Japanese Yen. The trade weighted Dollar Index from the Federal Reserve which charts the dollar against a basket of 26 currencies has gained 12.5 percent since July.
Oil, like all major international commodities is priced in dollars. As the value of the dollar rises, the price of crude drops as each dollar buys more oil. The price translation is not is one for one but acts as a strong reinforcement to the existing supply and demand trends.
The combination of excessive supply brought on by the relatively high crude oil price of the past two years and a world economy beset by slow or slowing economic growth in three of four major economic zones-- China, Europe and Japan—the United States may be an exception, has collapsed crude oil prices to levels not seen since the financial crash of 2008 and its aftermath.
Neither the supply nor the demand side is likely to alter in the next three quarters. Even if prices did begin to move higher, perhaps world economic growth will not be as flat as predicted, shale production in North America, almost all of which is profitable above $75 would act as a cap on crude prices.
Until the global economy resumes robust growth and demand oil prices will be restrained by current and latent production.
Chief Market Strategist
WorldWideMarkets Online Trading