Market and product

With all the noise and hoopla over the fall in crude oil prices, the predictions that crude oil will soon hit USD 20 (or USD 10) per barrel mark, the lifting of Iran sanctions over the weekend, the proposed beggary of oil exporting countries and sovereign wealth; media and analysts have gone into overkill trying to pin the blame. While it is tempting to assume that the fall in oil prices is solely responsible for the fall in the financial markets and is a direct fallout of a global recession, it may be a simplistic view.

The primary reason for the fall in prices is a supply glut of about One million barrels of oil in the markets each day. Add to those 500,000 barrels a day with economic sanctions being lifted on Iran and you can see the problem. Between the Sheikhs and the Shale producers from 2010 and 2014 the world simply produced too much, and all that extra oil has sent the price of crude down more than 70 percent in the last 18 months.

You may well ask what's a million to two million barrels a day of excess production in a world that requires approx 90-95 million barrels daily and why should it have such a huge impact on prices? It's hard to overstate the impact of what the fracking boom in the US did to global oil supply but let’s just say US crude oil production nearly doubled between 2010 and 2014 thanks to new and innovative techniques employed by the US fracking industry. It was expected that the Saudis would play ball with the US and roll back some of their production to offset some of the supply, but as history will tell you the Saudis did not do that. In fact they did quite the opposite. Saudi Arabia decided to increase production in order to maintain market share, hoping that the subsequent fall in oil prices would crush the US shale oil industry, who required higher prices to stay profitable. (It’s another thing altogether that the Saudis needed the price of oil to stay at 100$ per barrel to balance their budget.)

All of that oversupply is probably best illustrated in the chart below, from the International Energy Agency’s Oil Market Report

The math should add up now – below USD 100 a barrel, no one makes money, below USD 60 everyone bleeds and at USD 30 … (pardon my French) it’s just a bloody mess. Hence markets are panicking, commodity funds are blowing up and the House of Saud is selling its family silver- an IPO for ARAMCO! In the meanwhile key producers in the US and Middle East have begun cutting production and dropped their rig count even as dozens of small businesses have gone bankrupt That said, the supply glut continues as the oil industry cannot simply flip the switch on big projects like in the Gulf of Mexico where they have invested enormous capital.

So does the price of oil go back to the teens or sub USD 20 and stay there a while? There are numerous probabilities, all in the realm of geopolitics and sovereign interest, which is perhaps the most critical. Take a look at various forecasts: Banks like Goldman Sachs project oil prices to keep plummeting down to USD 20 per barrel this year. Others expect a rebound to around USD50 or USD60 per barrel by year's end as the US shale boom tapers off and demand recovers. Then there are the fence sitters who expect this USD 30-50 to continue till 2018.

Eventually it’s all about managing expectations and black swan events and those have been repeated ad nauseum in the pink pages. For example if the Iran/ Saudi conflicts escalate or ISIL war heats up and leads to disruptions that crimp production, prices could rise. Or if China's economy rebounds unexpectedly or maybe EU and US oil sanctions are back for Iran/ the Russians or some other major oil producer. At end of the day it's a guessing game, and there are lots of plausible guesses.

So when do we hit the bottom? No one knows for sure but common sense tells you as long as supply far outstrips demand, oil prices will stay relatively low. As for those who do know, you can be sure that when the time comes, they will be laying bets in the financial markets rather than writing articles about it.