It’s an easy mistake to make. If the value of an asset halves in six months, it’s not unreasonable to believe the bottom must be near. The temptation to try to time the turn can be irresistible, and painful – there’s a reason it’s called “catching a falling knife”.
When Saudi Arabia was preparing for the annual meeting of the OPEC oil producers’ club a year ago, it might have thought it had the upper hand. The traditional swing producer surprised energy watchers by refusing to balance the market. As the world’s biggest oil exporter, it gambled that maintaining production would quickly squeeze high-cost shale-oil producers in North America and allow it to maintain market share as the price of crude bounced.
That bet has apparently misfired. The oil price had already fallen from $US115 a barrel in mid 2014 to under $US45, and the prospect of $US30 oil no longer seems ridiculous. The Kingdom is the poorer as oil revenues fall short of domestic spending. A budget deficit amounting to 20 per cent of GDP looks possible this year, according to the International Monetary Fund.
Maintaining a balance in the global oil market is no easy matter because the net surplus or shortfall is the difference between two big numbers. That means a modest uptick in supply or a slowdown in demand can have a disproportionate impact on the price. It tends to overshoot in both directions.
Unlikely to rebalance soon
Goldman Sachs has warned that with oil inventories at record levels, the market is unlikely to rebalance soon. The amount of crude sitting in storage has risen for eight weeks on the trot and the supply glut is showing no sign of easing. Oil analysts are struggling to get their heads around a new world in which supplies can be turned on and off much more quickly than in the past. Shale supplies are more flexible than traditional sources of oil so any uptick in the price might easily be snuffed out as the switch is flicked on new capacity.
On the demand side of the ledger, the outlook is not much better. Japan, one of the world’s leading oil importers, has slid into its fourth recession in five years. China, the marginal buyer of most commodities, is undergoing a transition to a less energy-intensive phase of consumption-led growth. The OECD thinks the global economy could grow by as little as 2.9 per cent this year. Now even El Nino is being fingered – a warm winter in Europe on the back of the unpredictable weather pattern could crimp demand for heating oil.
The third headwind for the oil price is the increasingly likely divergence between monetary policies on either side of the Atlantic. With the European Central Bank likely to expand its quantitative-easing program on the eve of this year’s OPEC meeting and the Federal Reserve almost certain to increase interest rates two weeks later, further appreciation of the US dollar looks probable. With oil priced in the US currency, a rising dollar makes it more expensive for buyers in other countries and the price of crude tends to fall to compensate.
If Saudia Arabia holds its nerve
If Saudi Arabia holds its nerve at the upcoming meeting and the oil price does fall even further, the pain of the world’s already squeezed oil exporters will be matched by the gains for its energy importers. The biggest beneficiary should be the US. Although the US is a major oil producer these days, its economy is so vast that the energy sector only accounts for 2.4 per cent of GDP. That compares with more than 60 per cent in Saudi Arabia and Kuwait and more than 20 per cent in Russia. The benefit to the US of cheap petrol and lower input costs massively outweighs the hit to jobs and corporate profits in the energy sector.
The disinflationary impact of cheaper oil will keep the trajectory of interest rates in the US [flatter?] than would otherwise have been the case. It will ensure the Goldilocks environment of flat prices and modestly rising average incomes continues through 2016.
In the long run, the Saudi call will probably be right. Growing demand from emerging markets should more than offset the impact of clean energy and greater efficiency in the developed world. The market will rebalance itself in time.
The question is how long OPEC is prepared to stomach the high cost of keeping the pumps wide open.