Price cuts are good for consumers, but markets don’t like volatility.
The sharp decline in oil prices is a simple case of economics 101, in particular the laws of supply and demand. Brent crude oil prices surged from a low of US$20 a barrel in 2001 to US$128 a barrel in 2011.This led to a sharp increase in exploration and production while consumers sought ways to become more energy efficient and reduce their reliance on high priced oil.
Fuel conservation has reduced the demand for oil as new production came on stream. Thus, an excess of demand over supply in 2010 and 2011 quickly became an excess of supply over demand. As a consequence, oil prices have plunged.
The rapid transformation from excess demand to oversupply has had an impact on many commodities, including dairy, and has resulted in a sharp decline across a wide range of commodity prices.
The accompanying table shows that global oil supply has increased from 85.1 million barrels a day to 96.4 million since 2005. This totally contradicts Hubbard M King’s Peak Oil Theory, which he developed in the 1950s.
King, who received a PhD from the University of Chicago and studied petroleum reserves and production patterns, predicted that US oil production would peak between 1966 and 1972. He was correct in the short term but the development of fracking techniques has resulted in a substantial increase in the country’s oil production, from 8.3 million to 15.1 million barrels a day since 2005.
The United States is now the world’s largest oil producer and accounted for 60 per cent of the increase in world supply between 2005 and 2015.
Saudi Arabia is the second largest producer and Russia is third.
The Saudi Government introduced an austerity budget in December and the IMF is forecasting GDP growth for the kingdom of only 1.2 per cent in 2016 while the Russian economy is under huge pressure because crude oil accounts for nearly 60 per cent of the country’s export receipts.
The Brazilian economy is also under pressure because crude oil represents 11 per cent of exports and iron ore and sugar, which represent 9 per cent and 4 per cent of exports respectively, have also experienced major price falls.
Venezuela, with 95 per cent of its overseas income derived from oil, is experiencing its worst recession since the 1940s with its economy contracting by nearly 10 per cent in 2015.
Political conflicts also have a significant impact on supply as Iraq’s output has increased sharply since the reduction in hostilities but conflicts in Libya and Syria have led to significant output reductions.
But the biggest change over the past few decades has been the declining influence of Opec (Organisation of the Petroleum Exporting Countries). Opec’s share of world production has fallen from 41.6 per cent in 2005 to 40.5 per cent in 2010 and 39.1 per cent in the latest period.
Opec introduced production cuts to raise prices in the past but it hasn’t adopted this policy recently for a number of reasons including:
• Its influence over the market has declined.
• Saudi Arabia, which dominates the 13-member cartel, is much more interested in maintaining market share.
• Higher prices would encourage more shale oil developments in the United States which is not in the Saudis’ best interest. Opec’s best option may be to keep prices low and force US shale oil producers out of business, a development that would have a positive impact on prices in the medium to longer term.
• Iran, an Opec member, has been increasing production following the removal of sanctions.
On the demand side, there have been huge efficiency gains, particularly in the airline industry.
United States Department of Transportation statistics show that US airline fuel consumption was only 16,730 tonnes in 2015, compared to an all time high of 18,427 tonnes in 2007, even though the number of passenger miles flown increased by 3 per cent over the same period.
US carriers spent a record US$55.5 billion on fuel in 2008, declining to US$46.3 billion in 2014 and just US$30.8 billion last year. This is one of the main reasons why IATA (International Air Transport Association) is forecasting worldwide airline industry net profit after tax of US$33 billion for 2015 and $36.3 billion for 2016 compared with $17.3 billion in 2014.
The combination of rising supply and energy efficiency measures has resulted in a global crude oil oversupply of about 2 million barrels a day. As a consequence, inventories continue to rise with OECD stockpiles now equal to 98 days of consumption compared with 93 days at the end of 2014.
Opec is reasonably optimistic about 2016 and expects global daily demand to grow by 1.8 million barrels over the year while non-Opec supply is forecast to fall slightly. This would bring the market more into balance although these demand and supply forecasts are notoriously unreliable.
There is a widely-held belief oil prices will remain low throughout the remainder of the year and any recovery will be capped at the US$50/60 a barrel, rather than the US$128 achieved in 2011. The key variable to watch is the US output figures because there is unlikely to be a sustained price rise until a number of US shale producers are forced to cut production or cease operating.
There are clear signs of distress in the US energy sector, particularly Chesapeake Energy Corporation, the S&P 500 Index company based in Oklahoma City. Its share price has plunged from a high of nearly US$70 in 2008 to just US$1.70 and this week it notified the New York Stock Exchange that “it had no plans to pursue bankruptcy”.
The controversial company, which has aggressively acquired shale gas and oil properties in the United States, has high debt levels and plunging revenue and profitability.
Bank exposure to energy companies, as well as oil producing countries, has made investors anxious about potential loan write offs.
New Zealand is a small oil producer with output of only 0.053 million barrels a day in third quarter 2015 compared with 0.445 million in Australia, 1.923 million in Norway and 0.938 million in the United Kingdom, mainly offshore North Sea oil.
New Zealand’s petroleum imports peaked at $8.3 billion in 2010 then fell to $7.7 billion in 2014 and $5.2 billion last year.
The $3.1 billion decline in petroleum imports between the 2010 peak and last year is almost exactly the same as the decline in the country’s dairy exports from the 2014 year high.
The important point about oil and dairy prices is that they take some time to work through the economy so we haven’t felt the full benefits of the oil price slide or the full impact of lower dairy prices.
The New Zealand economy will clearly benefit if dairy prices recover, particularly if oil prices remain low, but an oil price recovery accompanied by further falls in dairy prices will be negative.
Meanwhile, the clear message from financial markets this year is that the decline in oil prices and other commodity prices has been too fast and too severe.
Financial markets and financial institutions prefer stability over extreme volatility and the rapid decline in commodity prices has been unsettling.
Financial markets will only settle down when commodity markets become more stable as this will indicate that supply and demand are more in balance.
Brian Gaynor is an investment analyst and the Executive Director of Milford Asset Management.