Over the past few months, both major crude benchmarks- Brent and Western Texas Intermediate (WTI) have corrected by over 25-30 percent from their 2014 peak.
Oil is in a bear market. Over the past few months, both major crude benchmarks- Brent and Western Texas Intermediate (WTI) have corrected by over 25-30 percent from their 2014 peak. Interestingly, and as it often happens in the financial markets, the timing of this plunge has surprised many. The fundamental factors behind the drop in oil prices—easing geopolitical tensions, slowing economic growth, especially in the Euro area and China, the Libyan output hitting the supply market again and the US shale oil revolution (the dominant factor) —could have been factored in well before and the plunge could have been smoother and more gradual, unlike the kind of capitulation we are witnessing now.
There are winners and losers in the backdrop of falling energy prices. Energy importers such as India stand to gain while producers such as Russia, already hammered by sanctions and a vulnerable currency, are feeling the pinch. Further, if one takes the deflationary environment the developed world, most notably Japan and the Euro zone, are entrapped in into account, one can argue that policymakers would not like to see crude below current levels. The recent move by the Bank of Japan to announce additional quantitative and qualitative (QQE) easing was not only a function of the impact of the sales tax hike on aggregate demand but also the potential impact on domestic inflation via importing cheap oil.
As things stand now, OPEC is very unlikely to cut production. According to the Wall Street Journal, Venezuela’s foreign minister asked to see Saudi Arabia’s top oil official at a climate-change conference on Margarita Island, off the South American coast. Ali al-Naimi, the Saudi oil minister, was expecting a plea to reduce oil output and bolster markets. But according to sources, Saudi Arabia won’t cut production on its own. Mr. Naimi is expected to repeat the message to delegates at a meeting of the Organization of the Petroleum Exporting Countries in Vienna later this month, according to Saudi officials.
But history tells us something different. OPEC currently pumps about half a million more barrels a day than its target of 30 million barrels a day, according to the International Energy Agency. Members are considering a commitment to rein in production to the group’s target level, OPEC delegates said, effectively cutting production sharply. Since 1984, the cartel has reduced output 11 times to address oil price falls, according to Deutsche Bank, with cuts totaling 1.24 million barrels a day, on average. This would help its member countries come closer to balancing their budgets. For example, Saudi Arabia needs Brent to average $99 a barrel to balance its budget this fiscal year, Deutsche Bank estimates.
The OPEC, however, might delay their plans to curb production. The group faces an additional dilemma—the US shale oil revolution. By pushing prices higher from current levels, the OPEC would encourage oil investments, including US shale production. As we know, the United States has flooded markets with new crude (adding roughly one million barrels a day each year to global supply), contributing to lower prices.
But its shale production requires relatively high oil prices to make money. According to Goldman Sachs, with crude at $75/barrel, 19 US shale oil regions will no longer be profitable. So the argument can be made that if weaker prices force some producers—particularly U.S. shale producers—to abandon their most expensive wells, then the market could eventually work in OPEC’s favor.
Currency Corner is of the belief that we are witnessing of the end of the commodity super-cycle which began in 1998. It is too early for OPEC to try and fight off the effects of US shale oil production which is a trend here to stay. There was a famous cover of The Economist magazine in the late 1990s which said that ‘’what’s in the ground can only go down’’. While, this column agrees that the long term trend in crude and energy prices is bearish, over the short term one can bet that OPEC will put a bottom to oil prices close to current levels.
By Vatsal Srivastava
Vatsal Srivastava is consulting editor for currencies and commodities with IANS. The views expressed are personal. He can be reached at firstname.lastname@example.org