Oil – What’s Going On?
For the average consumer, their primary connection to the oil market is through the price displayed at the fueling station. Indeed, oil and gasoline prices are very highly correlated, having 98% correlation and thus moving in near lockstep on the charts.
Oil prices have direct consequences in others sectors as well as economies as a whole. Given that it has few to no direct substitutes for most consumers, in addition to it being almost a necessity for households, oil prices and its derivative products, given their inelastic demand, have strong influence over household budgets. As prices increase, a larger portion of households’ budgets must be spent on it, leaving less to be spent on other goods and services. Demand for products across other industries decreases as a result of this. Additionally, the supply side of industries that use oil products as inputs, such as airlines or logistics companies, are impacted as well, causing the higher costs of production to be passed onto consumers.
As with all commodities, oil prices have seen their fair share of cycles. Historically, volatility is frequently a result of shocks to its supply and demand, due to any number of factors. The 21st century in particular has seen quite a few extreme cycles.
From 2003 to 2008, oil prices surged more than 450% from below $25 per barrel to a high of $147 per barrel. This increase was primarily attributed to producers failing to keep up with skyrocketing demand out of an unexpected economic boom in emerging Asian economies, such as China and India.
The 2008 financial crisis erased almost all of these gains from the preceding 5 years, failing from a high of $147 to a low of $33 in February 2009. Oil prices resumed their prior growth shortly thereafter because of strong growth out of emerging economies. Additionally, prices were stimulated by supply disruptions caused by geopolitical conflicts in the Middle East, particularly the Arab Spring. While the countries involved in these mass demonstrations against oppressive regimes were not significant producers of oil, investors and traders worldwide speculated that the protests could have spread to countries that were, particularly Saudi Arabia and Iran.
From 2011 to 2014, prices remained relatively stable around $100. However, in June 2014, prices collapsed into a bear market, dropping 70% over the next 18 months to a low of $35. This crisis was caused by a massive worldwide supply glut. Among the factors which caused this included massive overproduction by nearly all producing countries, decreasing demand a result of a poor economic performance in emerging and European markets, and the threat of future decreased demand stemming from new environmental policies which would steer energy consumption away from fossil fuels.
Up until recently, prices had recovered to around $80 per barrel. Financial news over the past few months have been littered with headlines such as “Oil Prices Plunge 9%” and “U.S. Oil Benchmark Sinks to Lowest Finish in Over a Year.” So, what’s happening this time?
Crude oil prices began to drop on October 3rd of this year. As with all the previous oil crises, there are multiple factors causing the nearly 30% drop thus far.
On the demand side, traders are beginning to price in the risk of decreasing demand as a result of weakening economic growth. Equity markets have been behaving similar, exhibiting significant weakness despite strong fundamentals. Especially in U.S. markets, the expectation of future interest rate hikes from the Federal Reserve after a near decade long bull market have resulted in a global risk-off environment that has spread to oil markets. The strengthening dollar also contributes to this decrease in demand as it is more expensive to buy the same amount of oil. Additionally, both OPEC and the IMF recently cut their forecasts of global demand growth, citing increasing trade disputes and volatility in emerging markets.
On the supply side, producers are both increasing inventory and output levels. Refineries worldwide are producing excess oil and storing them in stockpiles as they reduce production for seasonal maintenance. In the U.S., crews are returning to offshore oil rigs after a strong hurricane season halted 42% of Gulf oil output.
Recently, the U.S. imposed sanctions on Iranian oil exports. After this announcement, OPEC Russian, and American producers all moved to increase output to offset this expected supply gap. However, the U.S. government then recently granted waivers to eight countries who buy Iranian oil to continue to do so for six months until they can shift imports to other sources. Thus, there is an even greater excess of supply as Iran still gets to export its oil to the market.
Prices falling below key technical levels on the charts also contribute to the current bear market. Prices accelerated downward after breaching the 200-moving average and punching through lows established in February.
While consumers are not impacted directly by falling oil prices, derivative products may reduce in price due to lower transportation and input costs, leading to increased discretionary income and higher spending on other goods. Additionally, because of these lower input costs and falling prices, inflation will decrease, and real GDP will increase. All other factors constant, these falling oil prices are ultimately beneficial to the average consumer.