In this post I present some of my observations and thoughts about the developments in the oil price, supply and demand, exchange rates (relative to the US dollar), petroleum stocks and what near term factors are likely to influence the oil price.
- The price of oil (and other commodities) appears to have been influenced by the central banks’ policies post the GFC of 2008 (Global Financial Crisis, primarily the Fed as the US dollar is the world’s major reserve currency) with low interest rates which allowed for growth in total global credit/debt.
- As the Fed confirmed its end of QE3 (QE; Quantitative Easing) program by the fall of 2014, the oil price started to decline. This decline became amplified by an oversupply resulting from years of debt fueled high capital expenditures by the oil companies to develop supplies of costlier oil for the market to meet expectations of growth in consumption.
- With the end of QE3 the US dollar rapidly appreciated versus most other major currencies, which offset some of the decline in the oil price in most economies (oil is priced in US dollar), the exceptions being the US and China (which has its currency pegged to the US dollar).
- Demand and consumption of oil (actual data so far only for the US) responded to the price collapse by some growth. However the world’s growth has not been sufficient to close the gap between supplies and consumption, thus sustaining a downward pressure on the oil price.
- The oil price collapse motivated oil companies with low variable costs (OPEX) to compensate some of the loss of cash flow by increasing their production (volumes), thus creating a dynamic where growing supplies went looking for demand.
- The oil price collapse and a period with a favorable contango spread incentivized a strong build in stocks and as stocks remain at elevated levels, it may take some time before stocks return to “normal” levels.
The big unknown is how demand will develop. A global economy struggling with too much debt while running out of quality collateral will at some point experience the drags from growth in the services of the growing total debt. Continued growth in global credit/debt will increasingly be directed towards the services of the growing total amount of debt (kicking the can down the road as the economic productivity from additional credit/debt diminishes).
- As growth in global credit/debt slows, comes to halt or deleveraging sets in, this will affect demand and prices, also for oil.
Relative developments in some Exchange Rates and the Oil Price
As the Fed tapered and concluded QE3 in the fall of 2014 other currencies started to depreciate versus the US dollar. Exception is the Chinese one that is pegged to the US dollar. The depreciation of other currencies versus the US dollar caused an impairment of the purchasing power for consumers outside the US.
The oil price has declined faster/deeper than the currencies depreciated thus making oil cheaper/more affordable in most countries.
For most oil producers and exporters outside of the US the depreciation of their currencies (relative to the US dollar) has lowered their cash costs (OPEX as described in US dollar) leaving an incentive to maintain or even increase production to somewhat compensate for the decline in price with increased volumes.
For oil trades settled in US dollar a lower oil price means less revenues in US dollar for the exporters, thus less US dollars available for these to spend.
US Petroleum Stock levels
US commercial crude oil stocks started to grow as the oil price collapsed and levels remain unusually high, suggesting lower need to replenish during the fall season.
Supplies above consumption will be looking for a place to be stored. Developments in stock levels beyond the “normal” range serves as a proxy of the supply/demand balance. With a sustained oversupply inventories at some point will reach a level which it becomes challenging to move beyond. Suppliers may respond to such a situation by accepting a lower price.
OECD relative Developments in Petroleum Consumption
The growth in OECD petroleum consumption during the first half of the previous decade coincided with a period of strong credit growth, which also allowed for some tolerance for a higher oil price.
The high oil price of 2008 coincided with a private sector that had run out of space on their balance sheets for more credit/debt whereby sovereigns took over and increased their deficit spending. Synchronously several central banks acted in concert and deployed several monetary tools. At the same time China started an aggressive credit expansion pulling other emerging economies with it. All this to bring the global economy back to the previous growth trajectory.
This resulted in renewed support for growth in oil consumption and support for the oil price.
Total petroleum consumption for all OECD for Jan-Feb 2015 versus the same period of 2014 is up 0,84 Mb/d (1.8%) and the US is up 0.36 Mb/d (1.9%), likely driven by the decline in the oil price.
This time there are lots of things that are different from 1986, 1998 and 2008.
The most important is the significant growth in total global debt since 2008. Encouraged from what appeared as a sustainable higher oil price the oil companies used the increased assets/equity valuations as collateral to go deeper into debt to develop costlier supplies. All projections from those that matters (EIA, IEA and the major oil companies) showed expectations of growth in demand and consumption which would support a high oil price.
The oil companies thus entered into a bet that consumers would find more room on their balance sheets to take on more credit/debt which would support and sustain a high oil price.
Global Oil Supplies and Demand
Recent oil and gas discoveries are capital intensive and require long lead times from when decisions for investments are made until they start to flow. The trend in recent years has been the requirement for a higher oil price to make these profitable, and most estimates now put this price at around $70/b. Due to the capital requirements, the lead times involved for the harder to get to oil make the oil companies rely on predictable high prices.
Oil companies are now massively deferring investments in new supplies from a combination of reasons, primarily due to profitability outlooks and impaired financial capabilities from revenue contractions caused by the low oil price. This will at some point in time make it harder to offset depletion induced declines from the vintage(r) sources and will reduce the global oil supply potential.
Our societies are reliant on financially healthy oil companies. The recent oil price collapse impairs their balance sheets and should the price go higher in the near future, the oil companies still need more time to strengthen their balance sheets and gain reassurance that the higher price will be sustained before they in a meaningful way start to invest in the costlier to extract oil.
Our complex societies run on oil and are therefore dependent on financially healthy oil companies as these are the experts to explore for, develop, extract and bring to the market the oil our societies run on.
The dynamic created from growth in total global debt, which in some respects reflect how consumers’ obtained temporarily affordability for higher priced oil, will at some point in time have to face up to reality. This reality will manifest from consumers experiencing reduced access to credit/debt. This will affect the demand for and the price of oil.
The situation now has no precedent, therefore understanding the real drivers [future access to credit is one important one] of demand trajectories is imperative to understand probable future trajectories for the oil price. There is no way to rule out that the oil price will remain low for an extended period, resulting in an erosion of the world’s supply potential while demand remains lower.
A sustained low oil price while the supply potential declines and demand stays lower may easily support a false narrative. Many observers may point to the low oil price as proof that a declining supply is not worrisome.
Our societies run on energy surplus (NOT money!, our (virtual) financial systems are very much like the operating systems of a PC, tablet, smart phone etc, all of which does not function without energy).
A decline in the supply potential of our most important, non renewable energy source will also be a signal about our prospects to maintain our built complex infrastructures.
- The BIG UNKNOWNs going forward are; how will global DEMAND for oil and consumers’ AFFORDABILITY for higher priced oil develop.
Earlier I presented an analysis of oil demand and global debt in the post Changes to Total Global Credit Affects The Oil Price.
The analysis linked to looked at the relations between changes to total credit/debt and petroleum consumption for some big economies covering the years 2001 – 2013 based on data from BIS (Bank for International Settlements) and BP (British Petroleum).