Global oil supply has increased substantially in recent years due to rising U.S. production and other factors, leading to a sharp decline in oil prices from over $100 per barrel to under $60 currently. This drop in prices benefits consumers but hurts some oil-producing nations. While lower prices could reduce U.S. shale oil exploration and jobs in the oil industry, the effects may not be significant enough to change the Federal Reserve's cautious approach to monetary policy. Unlike past price declines caused mainly by falling demand, the current price fall is largely due to rising supply, a situation that could persist if OPEC doesn't cut production.

1. Time for an Oil Change
In 2008 fear of “peak oil” and thus the supposed decline of global oil
output was the dominant thought. Since then, U.S. oil production has risen
80%, to nine million barrels daily. The U.S. increase alone is greater than
the output of every Organization of Petroleum Exporting Countries (OPEC)
country except Saudi Arabia. For the past three years, oil prices hovered
around $100 a barrel as disruptions in Libya and elsewhere, coupled with
sanctions on Iranian exports, balanced out the production increases from
the U.S. and Canada. But the slower global economic growth that became
apparent a few months ago was accompanied by weaker demand for oil, just
when Libya suddenly quadrupled output to almost a million barrels a day.
The result: price weakened in September and then tumbled to its present
level below $60.
Is this time different? Supply and demand are all that matter when determining the price of an undifferentiated commodity
and oil is just that, an integral, invaluable but undifferentiated commodity. The price of a barrel of oil has fallen like this before
but almost always because of a demand shortfall. “This time is different,” said Guy Caruso, a former head of the U.S. Energy
Information Administration. Now, new supply—rather than demand—is dominating the market. OPEC estimated recently that
the world would need 28.9 million barrels of its oil per day next year, the lowest in more than a decade. At the same time, OPEC
countries alone plan to produce 30 million barrels of oil per day next year. That is over supply. Prices could stay relatively low for
some time.
Consumers Cheer. For drivers, shippers, airlines and other consumers of fuel, there’s nothing not to like about the drop in oil
prices. The national average gasoline price has fallen 3 months’ straight to $2.55 a gallon, its lowest level since October of 2009,
according to AAA. It’s $1.15 a gallon cheaper than its high for the year, saving U.S. households $100 a month as they shop for
holiday presents. Yessss!
Producers In Pain. The world may see some benefit from lower oil prices but some nations will be hurt, substantially in some
cases. Markets have been appropriately jittery as to how key
nations including Russia, Iran and Venezuela adjust to a 50%
or more shortfall in government income. Russia, for example,
is taking extraordinary steps to shore up its currency. A
wounded Russia leaves many observers nervous.
Oil and Jobs Growth. In all likelihood, shale production in
the US will continue at high levels through 2015, but gains
in employment almost certainly will not. Best estimates
suggest that shale oil and natural gas is economical to extract
at $60-65 per barrel equivalent; if today’s price stays low for
long exploration efforts will change. As the nearby graph
highlights, oil and gas industries own a disproportionate share
of job gains from 2007 on. This could be a big deal. Although
the Federal Reserve suggested today that it remains confident
in its US growth outlook, it stated today it will remain patient
in beginning to normalize its stance on monetary policy. A
measurable drop in oil / gas jobs could keep the Fed on the
sidelines even longer.
This time is different. Oversupply is estimated to be 80% of the
reason for the current drop in price. Global demand is weak,
but growing. The oversupply could be corrected with a small
production cut by OPEC but that is not judged to be in that
body’s best interest, yet. Enjoy the lower gasoline prices while
we have them and don’t be too worried about your portfolio.
At this point the risk is mostly that volatility might stay higher
while the oil price stays low. We will be monitoring the
situation closely and will keep you posted.
If you have questions regarding this weeks ‘Under the Hood,’ contact Chief Investment Officer, Mike Weiner.
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