The Independent Market Observer

The Risk of Higher Oil Prices

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Apr 22, 2016 2:10:37 PM

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oil pricesYesterday, I wrote that the U.S. economy, especially on the jobs side, remains basically healthy and even strong. At the same time, risks around the world seem to be receding. Chinese growth looks like it’s picking up, Europe also seems to be responding to central bank stimulus, and most of the things we were worried about over the past six months haven’t turned out so bad.

But, as they say, the bus you are watching is not the one that hits you. If the risks we were worried about are getting better, we need to look around and see what else might hit us. I would argue that oil is the most likely candidate.

Oil prices normalizing, for now

The basic narrative, which I agree with, is that prices are slowly normalizing to the marginal cost of production, around $40–$60 per barrel, and are likely to stay in that range. This argument, however, depends on a number of things continuing to go right.

Right now, world oil production appears to exceed demand, but not by that much, perhaps in the 1- to 2-percent range, per the International Energy Agency. That excess, however, includes Saudi Arabia pumping as fast as it can, other suppliers doing the same, and U.S. production declining but still strong. It wouldn’t take much for the excess supply to disappear as demand continues to increase and if suppliers cut back even a bit.

The current favorable conditions are therefore very likely to disappear over time, and in the event of a supply disruption, that could happen much faster. At that point, all of our worries about cheap oil would look kind of absurd.

The underappreciated benefits of cheap oil

A large part of the current recovery here in the U.S. (and much more so in Europe and China) is due to cheap oil. Lower prices have allowed consumers to spend and save more, have pushed up business profit margins (outside the energy sector), and have generally improved every economy on the planet. You used to hear a great deal about the damage high oil prices cause; nowadays, you don’t hear as much about the benefits of cheap oil.

You should. Europe and China both import two to three times more petroleum, as a percentage of GDP, than the U.S. does. Growth fears for both would be much worse with higher oil prices. Japan is even more exposed. As I mentioned before, China and Europe are getting better. If oil prices rise sharply, that will probably stop being true—and all of those global fears will return.

What if supply doesn't adjust?

Given current demand growth, even if supply remains constant, we should see that cushion erode in a reasonably smooth fashion over the next year or so, which would give markets time to adjust, allow production here in the U.S. and other countries time to increase, and keep prices within the $40–$60 range that the market seems to be expecting. If so, all well and good.

Suppose, though, that OPEC actually gets its act together (unlikely but possible). Suppose Iraqi production drops for any one of a variety of reasons, which is quite likely. Suppose ISIS manages to get some traction in Saudi Arabia itself. It's hard to tell how likely that is, but it’s certainly possible. Or what if U.S. production drops faster than expected? That alone could take out much of the excess.

With oil prices trending back up, it looks very likely that the supply/demand balance is already starting to return to normal. Prices are rising and will likely to continue to do so. If supply has time to respond, prices shouldn’t reach economically damaging levels but instead continue supporting economic growth while allowing the energy industry to function. This would be the sweet spot, the result we should be hoping for.

If supply can’t adjust, though, we might see prices spike by more than the market now thinks possible. In short, the one major unappreciated global risk is significantly higher oil prices. Be careful what you wish for.

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