Despite some proclaiming that the price fall was a sign of a weakening global economy, I suspect that increased supply has been mostly to blame. Since 2009, global supply of crude oil has increased from around 84 million barrels per day to around 94 million bpd. At the same time there has been a huge increase in the supply of energy from renewable sources. True, renewable energy still only accounts for a small percentage of total, but it is at the margin where its effects are felt.
"This is game theory at its purest"
The changing supply/demand dynamics in the energy industry represent a paradigm shift, something that the Saudis appear to have recognised. They know that the global economy can tolerate a price of $100 per barrel – after all, one barrel contains the energy equivalent of roughly twelve years of human work (based on 40hrs per week, 48 week working year) which would be valued much more highly – but also feel that they alone should not bear the responsibility for keeping it there, particularly in a world that is being weaned off the substance.
So, OPEC – for which read ‘the Saudis’ – has decided that if no one else is going to cut production, it won’t either. The resulting price fall has been forcing production cuts on the less efficient producers, rather than them being offered voluntarily. This is ultimately how a well-functioning market should operate, and demonstrates that the process of creative destruction is alive and well.
What perhaps is slightly unusual is that, unlike in most other industries, in the case of energy it is likely to be the most recent entrants – shale oil and renewable energy suppliers – who will get weeded out first, rather than the veteran incumbents in the Middle East. This is a shame, at least in the case of renewable energy, but should ultimately be seen as a good thing; the lower oil price will boost aggregate demand as well as increase pressure on renewable energy companies to improve efficiency further.
That said, I cannot see the oil price falling much below $50, despite Saudi oil minister Naimi’s unusually blunt comment that OPEC will not cut production even if the oil price falls to $20. This is game theory at its purest, with OPEC apparently attempting to engineer swift production cuts by higher cost operators so that the market can return to a more balanced state and prices back to normal, even if this is still well below $100.
The falling oil price was one of the factors behind the strength in the US Dollar but by no means the only one. Changes in expectations with respect to monetary policy are, as usual, the key factors. The reality is that by ending its bond buying program the Fed has been tightening policy. Furthermore, expectations are that the Fed will raise interest rates within the next year or so. In Europe and Japan on the other hand, expectations are for policy either to remain loose or to be loosened further. The rise in the Dollar has been exacerbated because of its status as a funding currency; as it starts to rise, many who have borrowed in US Dollars seek to pay them back, thereby adding to the strength.
The critical question I think has to be whether or not the global economy is at risk of sliding into recession. If the risk of this is low or negligible, as I think is the case given that central banks and governments generally remain very supportive, then the outlook for stocks should still be reasonable – after all, dividend yields are still decent while profitability of companies as measured by return on equity is not stretched.
In this regard, I think we still need to watch very closely for signs that the rise in the Dollar or the fall in the oil price is impacting growth in the US, the latter through closures of shale oil developments which have provided a boost to the economy is recent years. As of now, the yield curve is still steep (see chart) albeit it less so than a year ago, suggesting that a recession is not looming.
Published in Investment Letter, May 2015
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.
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