There are powerful dynamics impacting the oil and natural gas markets on a global scale. Our perspective is that the current downward momentum in crude oil prices was caused by a confluence of long-term factors ignited by some short-term considerations.
The United States and Canadian energy production boom started back in 2006-2007 and has kept apace since then. Growing supply though was countered in no small way by continued strong demand from China and other emerging market countries at the start of the production boom, and then later by rising geo-political tensions in Libya, Syria, Iran, etc., that served to mask any downward price pressures. In the last few years, however, China’s rate of growth has materially decelerated, and growth has slowed dramatically in most other emerging market countries as well, not to mention the economic stagnation that grips Europe.
The production boom in North America and the diminishing of factors influencing global demand set the stage for lower oil prices, but the catalyst came from elsewhere. When it became clear that despite worrisome developments in the Middle East, oil production was either coming back online (Libya, Iraq) or not being materially impacted, many longer-term investors, such as pensions and endowments, not to mention retail investors, began to shift their asset allocations back to a rising stock market and away from directionally bullish energy funds, including Exchange Traded Funds and Exchange Traded Notes (ETFs and ETNs), that were index-linked to a positive view on global energy prices.
The recent fall in oil prices has been quite spectacular. And, with the fall in oil prices it begs the question of whether supply will adjust. Indeed, if one focuses only on the actual production trends set against demand trends based on economic growth, one might be tempted to argue that sooner or later production cutbacks in response to lower prices would halt the current downward momentum. This view has risks in both directions.
- First, when powerful asset allocation shifts are involved, there is always a strong likelihood that markets can overshoot some hypothetical supply-demand valuation that fails to take into account the behavior of investors.
- Second, oil production tends not to respond to short-term price movements. A considerable proportion of oil production costs are in the capital investment phase, and these costs are often incorrectly (from an economics perspective) partly included in the perceived marginal cost of producing the next barrel of oil. In fact, production dynamics are much more complex, actual marginal costs are much lower than they might appear, and short-term production cuts are very unlikely.
- Third, and in the other direction, while the current situation in the Middle East (and Russia) has produced a relatively benign or grudging consensus that Middle East oil production will stay high despite the tensions in the region, one should not ignore the low probability, but high impact potential, of surprise oil supply shocks.
Our perspective is that the current decline in oil prices is probably 70 percent supply driven and only 30 percent demand driven. We also take the view that falling prices will not, at least in the short-run, have much, if any, impact on production. That is, supply will continue to expand, because the wells have been dug and the infrastructure built, and accounting versions of the marginal cost of producing the next barrel of oil considerably overstate, in our opinion, the very low costs and strong cash flow incentives to keep on producing. Moreover, we feel the role of traditional bullish-oriented investor groups, from pensions to endowments to the retail sector, have not completed the process of allocating assets away from indexed energy funds and towards bonds or equities. Thus, absent a major supply disruption, there may well be some more downward pressure coming in the market.
Read the full report on energy market dynamics here.