The Ups and Downs of Global Oil Prices

Any high school graduate should understand the law of supply and demand. So, why is the oil market so confusing?

One can be forgiven if one were to think that the price of crude oil is determined simply by supply and demand. As it turns out, something else is at play in the global oil market.

Here is an excerpt from a report by Bloomberg.com.

“While oil fundamentals aren’t strong, physical markets do not corroborate the substantial weakness in flat price,” New York-based Morgan Stanley analyst Adam Longson said in a report Monday. The “latest oil pricing pressure appears more financial than physical.”

A measure of returns from commodities sank to its lowest since 1999 Monday on concern that a slowing economy in China, the world’s largest consumer of energy and raw materials, will exacerbate supply gluts. Brent crude, the international benchmark, has dropped more than 30 percent since May on the ICE Futures Europe exchange in London. Prices rebounded 1.8 percent to $43.44 a barrel at 5:03 p.m. in London.

The stabilization of the price gap between monthly crude contracts and changes in the relationships between regional benchmarks suggests financial flows are behind the renewed slump, rather than a change in the physical oil market, Morgan Stanley said.

“This is very, very macro driven” with the focus on the outlook for China’s economy, said Paul Horsnell, head of commodities research at Standard Chartered in London. “It’s not based on any kind of oil supply-demand fundamentals.”

The Rapidan Group is an energy market and policy consulting firm in Washington, DC. In an interview for Real Clear Energy, Rapidan president Robert McNally explains what has been going on with oil prices.

The first price collapse late last year was caused by Saudi Arabia’s refusal to unilaterally cut production once some oversupply had developed. The most recent collapse was caused when the market realized shale oil was not going to replace OPEC as a swing supplier. The oil market is global. The US may have the best data transparency, but our supply-demand fundamentals alone do not set global prices. From 2011 to the middle of 2014 visible US data showed a weakening market – a surprising surge in shale production and lethargic demand. But oil prices remained firm around $100. The world market was harder to see, but relatively tight and disrupted.

More recently, the opposite happened: US fundamentals tightened this year in response to lower oil prices – shale is slowing and demand is robust. The spring crude price rally to $60 was driven by the notion that the US would balance the world oil market. But outside the US, a tidal wave of oil was silently building on massive Saudi, Iraqi production increases and resilient production in Russia. Inventories are at record levels and most balances show them building until well into next year. Finally, China’s economic weakness fed into weaker consumption. Like the Led Zeppelin remake went: “If it keeps on raining, levee’s going to break.” It’s breaking.

Over at Forbes.com, oil-and-gas-sector analyst Gaurav Sharma gives his take on what is happening.

As China’s so-called ‘Black Monday’ knocked the stuffing out of global equities and commodities market, yet another classic reactionary sentiment driven selloff in the oil futures space was glaringly obvious. By 15:47 ET, Brent October futures contract was down 6.27% to $42.61 a barrel, while the WTI was down 5.41% or $2.19 to $38.26.

Other than the whole wide world being spooked about China, which as a matter of fact is still importing oil at a decent if not historically high average of 7 million barrels per day, little else has changed. The supply surplus range of 1.1-1.3 million bpd is where it was, demand has not collapsed, and Iran has not yet added to the glut.

Yet, bouts of extreme volatility the oil and gas industry has faced at various points in its history made it pre-empt what is afoot – that at the time of a cyclical correction, things always get materially worse before they get better. Black Monday vindicated an industry already preparing for Brent seesawing from $40 to $60 per barrel until a modicum of supply-side stability becomes manifestly apparent.

The New York Times reports, “While the price [of oil] has been declining for months, forecasts have always been hedged with the assumption that oil would eventually stabilize or at least not stay low for long. But new anxieties about frailties in China, the world’s most voracious consumer of energy, have raised fears that the price of oil, now 30 percent lower than it was just a few months ago, could remain depressed far longer than even the most pessimistic projections, and do even deeper damage to oil exporters.”

Investopedia.com describes another factor that influences the price of crude oil: “For the past 50 years, the price of crude oil has been denominated in U.S. dollars. With the fluctuation in the value of the U.S. dollar and the prominence that newer currencies such as the euro are gaining, OPEC is considering switching crude oil from a U.S. dollar quotation system to either the euro or to a basket of multiple currencies. This could have an adverse affect on oil prices in the short run.”

The U.S. Dollar’s effect on the the oil market is mentioned in the Bloomberg.com article “Oil Traders Race for Cover as Light at End of Tunnel Dims”: “West Texas Intermediate futures tumbled Monday to the lowest level since 2009 on concern that Chinese demand is slowing just as Iran threatens to expand a global glut. Prices had risen on Aug. 20 as the outlook for a weaker U.S. dollar lured investors to oil, but the recovery was short-lived.”

So, instead of “Supply + Demand = Oil Prices”, it is “Supply + Demand + Financial Sector = Oil Prices”.

If Barbie thinks that math is hard . . .