Oil Prices: Going Down, Down, Down?

February 2016

Crude oil prices have been on a steady downward spiral since mid-2014’s $100 per barrel price, broken only slightly by a mid-February bounce amid speculation that OPEC might limit production. This freefall to prices in the thirties and even, at times into the upper twenties, was driven primarily by OPEC’s decision to eliminate the production ceiling limit it has employed in the past and to increase production to 31.5 million barrels per day. Although demand has been steady, overproduction has resulted in a supply glut. In addition, the increased contribution from U.S. production has added to global supply.

Increasing competition puts pressure on OPEC

The fundamental change in the energy landscape in the past five to ten years is a primary factor in OPEC’s move to pump up production. The U.S. has significantly increased its energy product utilizing shale and new technology, boosting potential world supply. From 2010 to the current day, the U.S. share of the global energy market rose from 6% to 10%. By mid-2014, increased U.S. production combined with other energy production began to exceed global demand, leading to excess oil inventory.

OPEC was unwilling to reduce its production further and give up additional market share in order to support higher prices. Instead it chose to ramp up production to try and maintain its dominant low-cost supplier position and market share. Consequently, the price per barrel has plummeted over 70% since mid-2014.

Reaching supply/demand equilibrium

Producers appear reluctant to cut back on production to balance supply and demand, although recent indications from OPEC, as discussed earlier, do appear to have promise. To date, while the U.S. is expected to reduce output in 2016, other countries and groups, namely Russia and OPEC, have not indicated any appetite to reduce production. Russia, in particular, with its weaker currency, is able to afford production that was previously uneconomical. In essence, it appears that this is a fundamental shift in the energy production market brought about by competitive market forces. Recent developments however, indicate a willingness on the part of some OPEC nations to at least hold production levels at January 2016 levels.

An important difference from other periods when oil prices dropped is the supply/demand circumstances. Historically, most timeframes when prices have dropped have been a result of lower demand and a poorer economic outlook; currently, it is due to increased supply outstripping demand. Unfortunately, as a major supplier, this hurts the U.S.


Highly correlated to the U.S. stock market

Falling energy prices have had a huge impact on the S&P 500, as can be seen when looking at earnings of the S&P 500 including and excluding the energy sector. At this point, over 76% of companies have reported their fourth quarter earnings, with a blended earnings growth rate of -3.7% year over year. Excluding the energy sector, the rate jumps to +2.4%. The magnitude of the impact is clearly illustrated by how tightly correlated the returns of the S&P 500 have become to oil prices.

Positive side to lower oil prices

There are also positive aspects to lower oil prices for sectors highly dependent on energy prices. Sectors such as manufacturing and transportation, are benefiting from lower expenses. For individuals, lower energy costs essentially translate into tax savings. As consumers continue to benefit from improvements in the employment picture, plus additional savings as a result of lower energy costs, this should lead to rising consumer confidence and spending, which will help to spur economic growth.

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