In this article, we are going to look at the causes behind the 74 per cent plunge in oil prices from a peak of $106.78 per barrel in June 2014 to a low of $27.10 on January 20.
In order to give you an "appreciation" of the oil plunge, let's have to look at the chart:
Source: Trading View
As oil prices declined, there have been numerous predictions that prices will recover in the past 18 months. However, we had not seen a meaningful recovery. The nearest we had was the double-bottom recovery in early 2015 as the US experienced a harsh winter (more demand for energy for heating) and on expectations of a strong US recovery. This quickly faded in the second half of 2015 as the US recovery was not as strong as predicted and China experienced the first of its many equity meltdowns in June 2015.
So why are oil prices falling? Simple supply and demand. This is how oil prices were determined a hundred years ago and this is how prices will be determined a hundred years from now. The main reason why oil prices has dropped so drastically is a direct result of oversupply.
As we can see from the chart above, there is a large oversupply of oil in the global markets. So what is causing this massive oversupply? In my opinion, there are three main supply factors:
#1 New Technology
I think most people know that the Middle East (and specifically Saudi Arabia) has the largest known reserves of oil in the world. While Saudi Arabia has the largest known reserves at 260 billion barrels, what is less known is that the United States is now the world's top oil producer.
Source: CNN Money
From 2008 onwards, the mass adoption of a new technology called "fracking" has allowed oil companies in the US to extract oil and gas resources previously thought impossible to reach. Fracking has allowed the US to steadily increase its oil production (and the world's oil supply) until it overtook Saudi Arabia as the world's top oil producer in 2014.
As oil prices plunged, Saudi Arabia was unwilling to cut production to steady oil prices. When Saudi Arabia refused to cut oil production, the rest of OPEC and other oil producing countries followed suit. The competition is so intense among countries that they fear permanently ceding market share to the rest if it cuts its oil production. Saudi Arabia also knows that low oil prices will eliminate foreign competition as other sources of oil production become too expensive to produce, so they have a secondary reason to keep oil prices low for now.
#3 New Entrants
Adding to the supply is the entry of Iran after sanctions were removed in January 2016. Iran has pledged to add another 500,000 barrels of oil a day and oil money is needed for Iran to catch up to the rest of the world economically.
OPEC and net oil-exporting countries like our neighbour Malaysia are obviously the losers as they earn less oil revenue. Malaysia derives 30 per cent of its revenue from oil and the plunge caused a fiscal deficit. Malaysia had to cut oil subsidies and introduce a 6 per cent goods and service tax to balance its budget.
Oil companies are also among the causalities. In 2015, oil companies in the United States cut over 120,000 jobs. Oil giant BP recently announced that it would cut 4,000 jobs over the next two years. Companies that provide services to oil companies are also badly affected. Schlumberger, a leading oilfield services company, cut 10,000 jobs in three months. The decline in oil prices had also increased the credit risk of lending to these oil and gas companies. This is putting financial stress on financial companies in the US.
The overall condition of the oil industry can be seen in the iShares Global Energy ETF (IXC). IXC is listed on the New York Stock Exchange and the ETF consists of 96 top energy companies like Exxon Mobil, Chevron, BP, Schlumberger, and Royal Dutch Shell. Hence it represents the fortunes of the entire oil sector and not performance of individual oil companies which may be affected by management.
After oil prices peaked at $106 in early June 2015, IXC prices peaked three weeks later the same month. While IXC performance lags the oil prices, it is clear that they have a positive correlation.
For the winners, economies that import oil such as the United States (yes, the US is still a net importer despite its record production), the Eurozone, Japan and China are all winners in this environment. The low oil price is similar to a tax cut for them.
The US has increased its domestic source of oil from 70 per cent in 2005 to 90 per cent in 2015. However, it still has to import the remaining 10 per cent from the rest of the world but it is increasingly less reliant on external sources. Ever since the painful oil shock of 1973, the US had made steady towards energy independence.
Airlines, whose main no. 1 expense is jet fuel, are also benefiting from the low oil prices. Lower costs mean better profit margins for airlines and the S&P Airline index rose steadily in 2014 as oil prices were tumbling.
Source: Financial Times
Transportation and freight will also benefit from lower fuel costs. The automobile industry will also get a boost as consumers choose to drive more and purchase new cars as fuel costs lower. Industries that use oil as raw material will also benefit - for example, companies that create your plastic bags and building materials from polymers that are extracted from oil product. As oil prices hit new lows, their cost of raw materials will continue to decline.
With the recent inclusion of Iran into the world's oil supply and Saudi Arabia's reluctance to cut production, the supply will continue to flow for the foreseeable future. Coupled with weaker demand due to China's slowing economy, it doesn't seem oil prices will rise drastically upwards anytime soon. Not great news for oil companies, but one I would gladly accept as a consumer who loves lower prices overall!
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