Stop worrying and learn to love cheap oil
In almost every financial cycle there comes a point when the publicly expressed views of analysts and investors diverge completely from market behaviour. Occasionally, this can be what George Soros has called a moment of truth, when investors suddenly realise that a financial boom has wildly overshot economic fundamentals and is about to turn to bust. But often it turns out that the markets have grasped a message that has not yet been consciously understood by investors — and it is analyst expectations that ultimately have to adjust.
Monday may have a marked such a moment in the oil and commodity cycles and their interaction with the world economy. Although the collapse of oil prices began more than a year ago, in July 2014, most energy experts, ranging from investment analysts and investors to OPEC ministers and “big oil” executives, have been in denial about the fundamental political, driving this market rout.
Even the prospect of Iran’s re-emergence as the world’s third biggest oil exporter, which was almost guaranteed to cause the next downward lurch in prices was initially dismissed by many analysts as a minor factor that would take until 2016 or even 2017 to affect global supply and demand.
But Monday may have been a moment of truth when investor expectations began to catch up with realities that many energy analysts have found it difficult (or unbearably expensive) to accept. A shift in psychology was suggested by the way that equity prices steadied and then rallied in New York, even as oil prices closed on their lows. This market behaviour, if it continues in the days ahead (a big “if”, of course), may imply that investors are no longer treating the collapse in oil prices as a leading indicator of global economic weakness and instead may soon start to recognise cheap oil for what it has always been and still is today: a very powerful
forces stimulant for global growth.
One reason investors have been slow to recognise the macroeconomic benefits of low oil prices is the state of denial among energy experts about the oil market itself. This phase of denial may also now be ending, as energy investors recognise the economic and political fundamentals that are likely to keep oil prices low for years ahead, even if the world economy accelerates strongly, as it did after the oil price crash of 1986:
1) Global oil supplies clearly exceed the probable growth in long-term demand. This is a consequence of potentially unlimited supplies of shale oil, not only in North America but also in Argentina, Russia and China. Meanwhile, on the demand side, steady reductions in the oil intensity of economic growth are inevitable because of environmental regulations and technological advances that are rapidly improving the economics of solar, wind and battery power.
2) The combination of technology, pricing and regulation above means that much of the oil that has already been discovered will never be produced and instead will become a “stranded asset” similar to most of the world’s known coal reserves. This means that searching for new oil reserves in high cost locations such as the Arctic and deep oceans is a monumental waste of money and a misallocation of capital that makes subprime property look like a prudent investment worthy of Warren Buffett. Yet drilling for oil in challenging locations is what many oil company executives still regard as their core competence.
3) Now that Saudi Arabia has realised that its oil reserves will become a stranded asset if it allows other producers to squeeze its market share, the oil trade has been transformed from a monopoly or oligopoly into a more or less normal competitive commodity market. Saudi Arabia or OPEC can no longer set a price and then defend it as that would mean cutting back Saudi production continuously to accommodate the increasing amounts of new oil that can be produced, even at high prices, in North America in addition to that which will again soon be available from Iran and Iraq, and eventually also Russia, Libya and Nigeria.
4) Geopolitical and security conditions are already so bad in many oil producing regions that military and political changes in the years ahead are likely to be conducive to more oil production, not less. And since prices are made at the margin, geopolitical surprises should now be viewed mainly as a major downside risk to oil prices.
5) As a result of the points above, oil prices are now determined by supply conditions much more than by demand. This is an important point about commodity pricing generally that Andrew Batson has discussed in his work on China and iron ore. It means that rising and falling prices should no longer be considered a leading indicator of global or Chinese GDP, but instead mainly as a function of supply conditions and production costs. Fluctuations in global economic activity or Chinese growth will have only a minor effect on oil prices in future, compared to the large swings in supply dictated by geopolitical events such as the Iran settlement or an end to Russian sanctions and the changing economics of shale.
6) Since oil is now priced in a more or less competitive market and US shale drillers have become the swing producers, the marginal costs of US shale production should be seen as a ceiling, not a floor, for the long-term price of oil. With fracking technology advancing and intense competition now forcing production costs and wages downwards, that marginal cost ceiling is turning out to be much lower than the $70 or so that many analysts predicted—and it is more likely to fall than to rise in the years ahead.