Quarterly Market Update
Increasingly apparent is the divergence of the pace of U.S. economic growth from the rest of the world. In this edition of BBVA Compass Market Outlook, Mses. Shackelford and Viguier-Galley examine global monetary policies and explore reasons behind some of the disappointing results.
In this edition of BBVA Compass Market Outlook, Mses. Gwynne Shackelford and Viguier-Galley examine the dynamics behind the 2014 oil price plunge and the anticipated impact on consumers, companies and markets in 2015.
1. Please explain the forces behind the seven-month decline in oil prices.
A supply glut combined with lackluster global demand sent the price of West Texas Intermediate (WTI) crude oil tumbling from over $100/barrel just this past summer to $55/barrel on December 31, down 46% for the year, the steepest loss since the 2008 financial crisis.
The daily national average price of a gallon of gas, largely determined by the price of crude oil, fell from a high of $3.34 a gallon on April 28 to $2.27 on December 31, 2014 according to AAA, the automobile club.
Prices began to drop in July and the decline continued throughout the year as the market responded to Europe and China’s continuing slow-down, increased shale-oil production in the U.S., and the decision in November by the Organization of the Petroleum Exporting Countries (OPEC) not to cut production despite falling prices. With a supply glut now coupled with demand destruction, we are witnessing an intense market correction reminiscent of the 1986 oil price decline. This decline will wring out excess producers, beginning with high-cost producers and those unable to quickly reduce production.
Figure 1. The price of oil has plummeted since the summer months.
Figure 2. The price of gasoline dropped by to an average of $2.27 per gallon by the end of 2014.
2. What are the supply factors behind the price plunge?
Technological advancements in shale-oil extraction are a large factor. As per the International Energy Agency (IEA), the U.S. was the third-largest oil producer in the world in 2012, behind Saudi Arabia and Russia. Thanks to advances in shale-oil drilling, it is estimated that U.S. production has increased by approximately one million barrels per day on an annual basis.1 Although a factor, gains in North American production have been years in the making, and therefore should not have come as a surprise.
Production in other countries is also a contributing factor. Because Russia’s economy is so energy-dependent, the drop in oil prices tends to generate additional production as the country attempts to make up the shortfall on volume. Also geopolitical unrest in certain areas of the world was relatively muted in 2014, allowing countries such as Libya to ramp up production.
Historically the world has looked to OPEC to be a ‘regulator’ of oil prices through the establishment of production quotas for member countries. But this past year, as demand and prices fell, OPEC members signaled their intention to keep their market share intact and allow prices to adjust to new lower levels.
OPEC’s decision to not cut production helps the cartel to use lower prices to squeeze suppliers with high production costs out of the market, allowing the cartel to maintain market share. Falling prices make marginal production prohibitively expensive, eliminating, or at least hamstringing, key competitors. Many U.S. and Canadian producers probably need prices around or above the $60-$70 per barrel range to break even, whereas the Saudis can withstand lower prices for longer give the Saudi Arabian Monetary Agency’s huge stock of net foreign assets, which totaled $736 billion at the end of November.2 Regionally, OPEC members like Iran and Iraq require a much higher price per barrel to balance their budgets, and thus these countries are disproportionally impacted by declining oil prices. In Russia, a non-OPEC member, political sanctions had proven ineffective in corralling the country’s aggression in the Ukraine. However, falling oil prices quickly accelerated the collapse of the Russian ruble in December, bringing considerable pressure to bear where economic sanctions had failed on the government led by Vladimir Putin.
3. What is behind the current price plunge in terms of demand?
Demand for oil is driven primarily by economic factors. The previously robust demand side expansion for consumption of petroleum products has slowed, especially from emerging markets like China, long a leader in oil consumption, which is transitioning from an exports- driven industrial economy to a services one. Stagnant growth in the Eurozone and Japan has also reduced oil consumption.
4. Are current oil prices justified based on these supply and demand factors?
The differential between demand and supply, estimated to be only a matter of a few hundred thousand barrels per day, is not large enough to warrant the sharp price drop. As per JP Morgan3, as of December 31, global production of crude oil was estimated at around 92 million barrels per day while global consumption was an estimated 91.4 million barrels per day.
5. What are the positive impacts of lower oil prices?
Similar to a tax cut, the drop in prices is a stimulus which boasts consumer confidence, and subsequently, consumption. The BBVA Economics Research Department in the U.S. (BBVA Research) estimates that a drop of $10 in the price of oil leads to a drop of 25 cents in the price of gasoline. Households save $270 per year for every 25 cent drop in gasoline price, and thus consumption could increase $100 to $110 billion in 2015-2016. As a result, lower oil prices could potentially add 20 to 40 basis points to our base estimate of 2.5% U.S. GDP growth.
The falling foreign oil bill is also shrinking the U.S. trade deficit which fell in November to its lowest level in almost a year. For the first 11 months of 2014, U.S. energy exports were up 9.6% compared with the same period in 2013.4 The price drop also helps global economies at a time when there is widespread concern that Eurozone countries are teetering on the brink of another recession. Because oil is priced in U.S. dollars, it is not as cheap to non-U.S. purchasers due to the strength of the U.S. dollar, but nonetheless there is some kind of stimulus effect of lower prices.
6. What is the anticipated negative impact of lower oil prices?
In general, the macro level implications of lower oil prices are positive for all net oil consuming countries, including the U.S., Europe and the major Asian economies of Japan, China, and India. The “losers” are oil-producing states and countries, and low quality energy companies. Certainly net oil-exporting countries like Russia that are heavily dependent on oil revenues and require a higher price per barrel to balance their fiscal regimes are hurting from the price decline.
At the state level in the U.S., the impact will have regional distinctions – Alaska, Texas, Oklahoma, and North Dakota, the largest oil producers, will probably be negatively impacted. For example, in Texas, the recovering economy and the oil and gas boom have helped the state end the year with $6 billion in the coffers.5 But sales tax collections constitute the state’s largest revenue source, and the oil and gas industry is one of the largest payers of sales tax, generating about $2 billion a year,6 or slightly under 10% of the total.
At the company level, capital spending at energy companies is taking a dramatic and immediate cut, reducing spending on new exploration projects, and higher cost operators will struggle to raise money and pay off debt.
7. In your opinion what is the longer-term implications of the oil price decline?
A drop in oil prices driven by increased supply, such as an increase in U.S. shale oil production, should have a net positive effect on U.S. growth with the negative impact on the oil sector compensated by a boost to households’ disposable income. Conversely, price drops driven by lower demand attributable to a global slowdown, are a negative.
A mixture of issues aside from supply and demand, including the strength of the U.S. dollar and speculative forces within the market, have exacerbated the price swings. If prices fail to stabilize once the supply side is wrung out, that would generally indicate a global economic slowdown which leads to financial markets dropping. We do not believe this is the case, but there is some element of demand destruction, with short-term economic growth insufficient to support the growing consumption of commodities. The decline in oil prices is having a major impact on headline inflation, but the pass through to core prices which strips out food and energy, and the measure to which the Fed looks, has been relatively limited.
8. What are your recommendations for investors?
In the short-term, elasticity of demand is low, although it is higher in the long run, and oil prices are unlikely to climb back to over $100 a barrel. As demand grows and domestic shale developments slow, over-supply should adjust and prices stabilize, eventually reverting to around $60 to $70/barrel in 18 to 24 months. IEA forecasts that Brent crude oil prices will average $58/barrel in 2015 and $75/barrel in 2016, with annual average WTI prices expected to be $3/barrel to $4/barrel below that of Brent.
Investors are looking at this from an opportunistic rather than fearful vantage – currently our most common question from clients is whether or not we are buying energy stocks. But an old investment adage cautions against attempting to catch a falling knife.
Oil prices have fallen too much, too quickly, and need time to settle at the bottom, which may take time.
1 Deutsche Asset & Wealth Management, Energy Update, December 2014, contributor Kevin Hopkins, Credit Research.
2 AP Wire, By Abdullah Al-shihri and Aya Batrawy, Yahoo News, December 25, 2014, http://news.yahoo.com/saudi-dig-reserves-2015-budget-134850025--finance.html.
3 Source: EIA, FactSet, J.P. Morgan Asset Management. *Forecasts are from EIA Annual Energy Outlook and start in 2013.
4 Falling Foreign Oil Bill Shrinks U.S. Trade Deficit, Associated Press, Austin American Statesman, January 7, 2015.
5-6 Oil Slump May Force Small Ball,” by Kiah Collier, Austin American Statesman, page A1, January 7, 2015.
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