Oil – what’s happening? And, what to expect next?

Oil – what’s happening?And, what to expect next?

The OPEC meeting which concluded in Vienna on the 27th November 2014 sent oil prices plunging to their lowest levels in 4 years. The OPEC group decided to keep their oil production output constant at 30M bbl/day for the next six months. This decision caused Crude Oil – Brent (NYMEX) to fall 9.6% on 28th November 2014, its biggest single day drop in the last five years. Crude Oil – Brent was down 36.1% y-o-y on 28th November 2014.

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Source: S&P Capital IQ

Very few people would have placed their bets on the dramatic fall of oil and not many would have got their minds around the factors which actually caused this havoc. The price of oil is determined by the supply-demand factors in the market and this year these factors decided to play against oil. We begin by looking at the factors that are playing an important role in destroying the current oil prices and then conclude by analyzing what’s in store for the near future.


1. Shale production in the U.S.

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Source: U.S. Energy Information Administration (graph produced from the data collected); 2014 figures are until September 2014

Shale production is top-of-mind. This is one of the latest technologies adopted by U.S. to extract oil at lower cost. The U.S.’s ambition to be energy self-sufficient by 2020 is boosting the global oil supply. New oil-extraction technology has increased per-day oil production by 55% in the last 10 years or at a staggering compounded growth rate of 4.5% pa. The U.S. is said to have started what is termed as an indirect price war with the OPEC group; it is yet to be seen who will blink first.

2. Resurgence of the U.S. Dollar

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Source: Datastream (graph produced from the data collected)

One of the biggest factors hurting the Oil is the resurgence in the U.S. Dollar. The major commodities in the world are traded in U.S. Dollar and, not so surprisingly, as the U.S. Dollar gains value it affects commodity prices inversely. The chart above shows this relationship stretched over fourteen years. With U.S. economy on its way to recovery, oil prices are likely to suffer a commensurate drop. Below is the table showcasing the correlation between the two:

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3. Increase of production and export from the disrupted economies

Increased production and export from many recently-stabilized economies will likely add to oil’s price woes. The table below lists a few countries which are set or have already resumed production and exports:

Iran An accord on nuclear deal could add up to 1 million more barrels of oil in the market.
Iraq A war inflicted nation is getting back on track. It was producing 3.21 bbl/day in August 2014 up from 2.4 bbl/day in 2010.
Libya Libya produced 530k bbl/day in August 2014 up from a mere 100k bbl/day in 2011 when the country was hit by a revolutionary wave.

4. Slowdown of the Dragon economy

China became world’s biggest net oil importer in September 2013, surpassing the U.S., with consumption driven by faster economic growth and strong auto sales.

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Source: Datastream (graph produced from the data collected)

The chart above shows a strong correlation between the Chinese imports of Crude Petroleum Oil (unit of measurement: ten thousand metric tonnes) and the price of Crude Oil Brent (US$/BBL). This relationship is further affirmed by the following correlation matrix between the pace of Chinese oil imports (both volume and value) and the Crude Oil Brent price:

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The Chinese economy was largely responsible for pulling and guiding the world through financial crises. Now, it is slowing down, and it’s not surprising that its slowdown hurts oil.

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• Oil producers

First of all, the U.S. oil producers will be adversely affected as revenues dry up in the face of sustained high fixed extraction costs. In the 1980s, oil prices declined and oil producers companies suffered large financial losses. Many were forced to declare bankruptcy or to recapitalize their balance sheets. If oil prices continue to decrease over a long period, extraction companies with strong balance sheets will continue to offer their services for the same fees during the downturn. This will result in small crude oil and natural gas exploration and production companies encountering financial difficulties. According to EIA, the average breakeven for unconventional plays in the U.S. is US$76- 77/BBL. Given the present asset levels, oil prices persisting at current levels would likely lead to a slowdown in oil producer’s spending.

• OPEC group

Another group that is expected to be adversely affected by the lower Oil prices is the OPEC group. Oil is the major contributor to most of these countries’ fiscal revenues and most of the nations have already ruled out the possibility of cutting production. Most of the nations are bleeding, as the prices have fallen well below their breakeven Oil prices. The table below depicts where the breakeven prices for these nations stand as of 2015.
Fiscal breakeven prices for selected states (US$/BBL).

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• Downward pressure to continue

We all need to realize that we are now in the US$70/BBL oil world. This oil range is certain to put pressure on many oil producers who rely on high oil prices for profitability. OPEC’s decision to stay put with the oil production will surely put U.S. under pressure and it will be interesting to watch if U.S. decreases the production going forward. Mind you, the break even prices for U.S. producers is US$76- 77/BBL. This means that lower oil prices are here to stay for at least the next year or so. According to eight analysts’ reports compiled by Reuters, the current price level might potentially force the U.S. to reduce shale production and might also spark acquisitions of companies struggling under lower prices.

• Oil volatility

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 Source: Thomson Reuters Eikon (graph produced from the data collected)

The open interest building in the oil put options on XLE is about the highest in the year. Volatility is expected to persist due to the following factors:

  • There is enormous uncertainty about how low and how long prices might have to fall to shut in excess shale production
  • OPEC’s own response remains unclear in the medium term. The core producers in the Gulf region are expected to have the financial resources to withstand a prolonged period of lower prices by drawing down on their reserves
  • The pace at which the Iran sanctions weaken is hard to predict. I already mentioned that additional oil supply in the market will put further downward pressures in the prices
  • China and the other Asian economies, which were the demand growth engine for oil, are slowing and this adds to uncertainty

• Market Sentiment

Lastly, I would like to touch upon the market sentiment.

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Source: Thomson Reuters Eikon (graph produced from the data collected)

I tried to look at the relationship between the ICE Brent Crude Futures, Oil Volatility Index and S&P 500. The above chart depicts that stock market’s tendency to do well when oil falls; therefore, it is not a surprise that market has been cheering the oil downfall. This time around, however, the relationship may alter, as the lower prices of oil with the uncertainty might add to deflationary pressures in a few nations. It is yet to be seen how the market reacts to the consistent lower price level of oil.

• Who is going to be impacted

Let’s look at a couple of sectors which have got impacted by the oil prices.

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The above table shows the correlation between the oil price change and Canadian consumer and energy indices price change over a month (November). It is clearly seen that energy sector which is closely related to the oil prices suffered the most. The consumer sector however performed well over the last one month and this is expected as well, the lower oil prices translate into higher disposable incomes through different channels for consumers and encourages consumer spending in the retail space and this is expected to be the trend until oil gains stability.

[box type=”shadow”]Rohan Bhargava is a Research Analyst for the Rotman Asset Management Association. He will be graduating from the MBA program at the Rotman School of Management in 2016. Rohan can be reached at Rohan.Bhargava16@rotman.utoronto.ca [/box]

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