Oil off the boil
West Texas Intermediate oil fell below $90 for the first time in 17 months amid signs that supplies from Russia, Saudi Arabia and the U.S. are outstripping demand. Brent, Europe’s benchmark, headed for a bear market.
That was the opening of a Bloomberg report published yesterday morning, under the headline “WTI Oil Plunges below $90 on Supply Glut, Brent Declines”. The ‘bear market’ referred to with regard to Brent crude, by the way, means that its price is almost 20% below its most recent peak — the standard definition of a ‘bear market’, as opposed to a mere ‘correction’. However, these are just traders’ milestones for measuring moves and have no substantive importance.
The absolute price of oil, however, has massive substantive importance. It is by far the most important commodity in the world and entire nations depend on it for their well-being or riches, as the case may be. For that reason, the direction of any move in the oil price, the size of that move and, above all, the cause of it, are critical matters.
The mere fact that the price has been trending downwards for several months — the peak was in late June — is surprising, as has been noted here before. After all, with several key oil producers mired in crises, wars with their neighbors and even civil wars, there was ample reason for the price to rise, just on ‘geopolitical concerns’. Yet the opposite happened.
The Bloomberg headline includes an answer which is fleshed out in the story itself — ‘supply glut’. Before drilling deeper into this claim, let’s emphasize that this is undoubtedly the correct answer, in that the price could only have gone down if there were more sellers than buyers. That may sound obvious, but when constructing complex analyses it is always useful to remember the basic truth of all markets: if prices fall, it must be because there are more sellers, and conversely if they rise.
The analysis must therefore focus on two sets of questions — firstly, who are these sellers and how comes they have gained control of the market, then secondly, what has become of the buyers? If there are as many buyers as previously, then the change has come on the supply side — the sellers have more to sell, for whatever reason. If, however, there are fewer buyers than previously, then the explanation to what has happened has to be sought on the demand side.
In journalese, the first scenario is telescoped into ‘supply glut’, and that is the main idea that the Bloomberg piece develops. There is excess supply because a) American production is increasing very rapidly, b) the Saudis are still pumping at near to full capacity, c) so are the Russians, d) Libyan production has improved and e) bit players like the Kurds are also bringing more oil to market. All this makes sense and provides a clear explanation, leading to the next level of the analysis, which asks what might each one of these producers do in response to the sharp price drop.
However, there is an alternative analysis, which puts more emphasis on slack demand. This shifts the focus back to the buyers, more correctly to who is not buying. Some people believe that Chinese demand has dropped, either because the Chinese government has ended its (unannounced but rumored) build-up of a strategic oil reserve, or because of the slowing pace of growth in the Chinese economy.
Beyond that, there is the wider weakness, in Europe and in many developing economies, which translates into lower demand — or at least slower growth in demand — for oil. This is part of a general picture of declines in most commodities, which attests to economic weakness. But none of this contradicts the “excess supply” argument, which is based on hard facts of production and sales. Rather, both may be true and the two factors — excess supply and weak demand — actually reinforce each other, resulting in what has become a very sharp decline.
Yet precisely because oil is so central to the global economy, a sharp decline in price will tend to generate a reversal, as will a sharp rise. Let’s start with producers: as the price falls, marginal production becomes uneconomic — and this is especially true in the new American wells, because the new drilling techniques are so expensive. Falling prices also cause swing producers — mainly Saudi Arabia — to reduce their production, in an effort to push the market back toward balance.
Meanwhile, for consuming countries, cheaper oil is equivalent to a tax cut that puts more money into people’s pockets — but doesn’t cost the government, rather it helps boost revenues — so that economic growth picks up. In other words, as prices drop, both producers and consumers will react, eventually establishing a new equilibrium.
But it’s also worth remembering that prices below $100 a barrel are a source of discomfort to Iran, whilst below $80 the Iranian economy will collapse — irrespective of the sanctions’ regime.