Why Do Oil Prices Keep Dropping?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Aug 15, 2014 3:21:00 PM

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MarketOutlook_1As I write, the financial markets are dropping on fears that the situation in Ukraine is about to escalate. This doesn’t come as a surprise, and, frankly, it’s not very interesting from an economic point of view.

More striking is that oil prices have continued to decline despite this turmoil and everything else that’s happening around the world, particularly in Gaza and Iraq. Down more than 2 percent this morning, crude prices are at monthly and quarterly lows, and they're getting very close to annual lows as well.

Defying expectations, oil remains surprisingly cheap

Besides growing geopolitical turbulence, there are other reasons oil prices should be on the rise. The U.S. economy is growing, Chinese growth has returned to high single-digit levels, and even Europe is recovering (though it’s recently hit a rough patch). Plus, the U.S. summer driving season is in full swing, which typically sends prices higher. 

So why haven’t they gone up? Recently, I reviewed an excellent Deutsche Bank commodities report that presented several points worth sharing.

1. Supply is rising. I’ve written about the growth of U.S. production, but that’s far from the whole story here.

  • Iraqi production, for example, has recovered to around 3.3 million barrels per day (MBPD); it’s forecast to hit 4 MBPD (a 20-percent increase) by the end of the year and 5 MBPD (a 50-percent increase) by 2020. 
  • Canada’s production is projected to grow by 1.2 MBPD over the next five years, and Brazil’s by 0.9 MBPD.
  • For the top 10 oil-producing countries in the Deutsche Bank list, total production should increase by more than 7 MBPD over the next five years, or 1.4 MBPD per year. 

2. Oil is very expensive in historical terms. As a percentage of GDP, oil weighs in at around 4 percent, just about double the average of 1.9 percent for 1986–2003. Using more recent data, crude oil is at twice the average price of 2002–2012. On this basis, crude oil is the most expensive commodity in the world. This doesn’t necessarily mean prices will drop, but it does mean the potential for further increases is much lower.

3. Producers have incentives to open the taps. With current prices low, countries that depend on oil revenues to balance their budgets, such as Russia and all the OPEC members, either must produce more or run deficits. Russia, for example, has an estimated breakeven price of about $102 per barrel. Any further declines mean that Russia and others have some tough decisions to make about whether to increase production, which could potentially drive prices down even further.

4. Demand growth is weak. Aggregate world oil demand is expected to grow around 1.2 MBPD over the next three years. Looking back at point #1, that’s well below expected supply growth, and current imbalances should only get worse over time. Notably, this demand growth estimate is heavily influenced by China, which constitutes 34 percent of it. Any Chinese slowdown would have a material effect, weakening demand growth even further.

Is U.S. production the key driver behind lower prices?

As geopolitical tensions continue to mount, I would argue that the key factor in keeping prices down has been the growth in North American oil production. As a stabilizing force, U.S. and Canadian production has been incredibly valuable. A major part of our move toward becoming a price setter, increased domestic production is already benefiting both the U.S. and the world as a whole. 

There are, however, some less obvious side effects that also warrant mention, and I’ll get into those next week. Have a great weekend!

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