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Oil: The highs and lows of cyclical commodities

 

OIL PRICE ANALYSIS

Oil is so much more than a fuel. It’s a force even bigger than its trillion-dollar market. It’s a weapon, a strategic asset, a curse. It’s a maker and spoiler of fortunes, a leading indicator and an echo chamber. Each has a part in determining oil prices.

THE BACKGROUND
During the mid-20th century, a group of multinational oil giants known as the Seven Sisters (including the companies that became Exxon Mobil, Chevron and BP) dominated the market. Controlling the barrels from the wellhead to the gasoline tank, they traded mainly with each other on confidential terms; there was no open market. Countries with oil fields wrested more control with the formation in 1960 of the Organization of the Petroleum Exporting Countries. The cartel’s Arab members used their power for political and economic ends, shocking the global economy with an embargo in 1973. Prices spiked again in 1979 because of the Iranian revolution. In the 1980s, OPEC infighting, the emergence of new suppliers and the development of futures exchanges gave rise to new market-based prices. Today the international benchmark is Brent crude from the North Sea. The U.S. benchmark, West Texas Intermediate crude, which for years traded at a discount to Brent, has been close to parity in 2016.
The U.S. repealed its 40-year-old ban on exporting crude in December.

THE SITUATION

After four years when the highest average oil prices in history seemed to defy economic gravity, petroleum began to plummet in mid-2014. Prices dropped as much as 75 percent over the next 18 months, throwing oil producers into turmoil and roiling global markets. Supply had expanded as the sustained higher prices made techniques such as deep water drilling and fracking pay off. Then China’s economy slowed and its imports sagged. Instead of staunching the glut by pumping less oil, Middle East exporters engaged in a price war to defend their market share. Adding to the oversupply, Iran was poised to ramp up exports after an agreement to curtail its nuclear program lifted economic sanctions.
The price collapse has forced high-cost drillers to idle rigs while international giants like Chevron, Shell and Halliburton cut thousands of workers and billions of dollars in spending. In early 2015, oil briefly rebounded above $50 a barrel after the conflict in Yemen. A year later, heightened tensions between Saudi Arabia and Iran — a situation that once might have caused fears of a disruption in supplies — failed to stop the rout and oil prices sank to the lowest level in a dozen years.

THE ARGUMENT
Few analysts expect oil prices to return to the prices seen a few years ago any time soon, giving rise to the idea that this could be a new era of energy abundance. It’s a blessing for gasolineguzzling consumers and a curse for governments in countries like Venezuela and Nigeria, whose fortunes are tied to energy sales. U.S. producers say the shale revolution — which made the country the world’s biggest producer of oil and gas — has freed it from fears that Middle East conflicts will cut off its supply. Some industry-watchers worry that bargain prices will begin a period of under-investment in oil production that could set the stage for another surge in prices. Saudi Arabia is leading other OPEC
members that want to maintain production, but the cartel is torn over a long-term strategy. Meanwhile, environmentalists worry that cheap oil will increase energy consumption and slow the shift to cleaner fuels that would help fight climate change. Longer-term, though, remedies for global warming could have a dramatic effect on oil, if governments favour policies to keep crude in the ground. But oil companies say the future includes rising energy demand and population growth, making oil an important fuel for decades to come. 

If you would like to discuss how this analysis may impact your portfolio please contact your adviser at Hamilton Hindin Greene.

 (Bloomberg)

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