What’s Behind the Plunge in Oil?

In the wake of a widely unexpected, huge oil price decline, I have received many questions and comments.

Some speculate US pressure on Saudi Arabia to punish Russia. Others think “big oil” is out to punish the frackers.

I responded to a friend today that the explanation is simple. No conspiracy theories needed. This was my proposal.

Explaining the Plunge in Oil

Slowing global economy, especially China and Europe US production expansion OPEC pumping above quotas – they all cheat Iran embargo failing Increased fuel economy Attitudes of millennials towards cars and driving

I give heaviest weight to number one, but they all cascade.

To maintain revenue with US producing more of its own oil, OPEC members cheated more to maintain revenue. Increased fuel economy and attitudes of millennials are longer-term factors, but they become more important as demand drops due to the slumping global economy.

Discarding Conspiracy Theories

I am a big fan of Occam’s Razor, a principle that suggests the simplest workable explanation is likely to be the best one. (For a tie-in to bank lending, please see Occam’s Razor and Bank Lending.)

In this case, a slowing global economy thesis is a far simpler explanation than the notion that the US pressured Saudi Arabia and OPEC, and both of them agreed to cooperate, simply to punish Russia at the request of the US.

Did that happen? Not likely!

OPEC and or “Big Oil” attacks on frackers are equally ridiculous for exactly the same reason.

Reflections on the Price of Oil

Just minutes after I responded to my friend, a contact emailed an interesting report on “The Price of Oil” by Dieter Helm.

Helm dismisses peak oil, I don’t (and to a certain extent he misses the construct), but much of the rest of what he has to say is accurate enough.

Helm states “Around the world high prices triggered the search for new supplies.“

That’s certainly a true statement, but in the next breath he states “It has turned out that the earth’s crust has plenty of oil and gas left, that R&D is not confined to non-fossil fuels, and that there are physically abundant supplies for decades to come. The problem is not an imminent shortage of oil and gas, but rather a super-abundance, enough to fry the planet many times over.“

The idea of a “super-abundance” of oil is ridiculous. The US saw an increase in production not because there is abundant supply, but rather because prices got high enough to make diminishing supply profitable to exploit. After all, that’s what peak oil is about.

And with this plunge in oil, new development has come to a halt. Many of these drillers are not profitable at these prices and huge numbers of bankruptcies will result.

OPEC to the Rescue?

Helm is on target with comments regarding OPEC.

It is claimed that OPEC will come to the rescue. Since the oil producers have squandered the revenues from the price increases, they now need high prices to keep on buying off their populations, especially in the Middle East where Arab Spring revolutions in several countries has scarred authoritarians and dictators. It is claimed that many of the key players need a price of $90 a barrel or more. The idea that because of the waste and corruption and populist spending, these countries can therefore enforce a particular price on the market is nonsense. A price can only be imposed if they all agree, they all actually cut production and the consequences of their behaviours is not to cut demand and increase non -­‐ OPEC supplies. None of this is likely to be true. The first point to note is that OPEC’s market power is waning. The US (and North American) production has transformed the market. The US is still over 20% of global GDP. Half its trade deficit was oil and gas. Now the US and the rest of North America are well on their way to rough energy balance. That is an enormous withdrawal of demand from OPEC. Europe is also reducing demand and economic growth is flat. China is slowing down and developing alternative supplies. It is now much harder in theory for OPEC to call the market. But even if it did want to fix the price, the mechanics are also a whole lot harder than they were in the 1970s, the last time it really had much impact. There are two myths about OPEC. The first is that Saudi Arabia can on its own increase or decrease production enough to make a difference. This is true now only in the very short term, and it would have to make a really big reduction to offset other increases, it would make a big hole in its budget and the result would be to encourage an even faster diversification away from it, notably by the U.S. …. Second, the fracking genie is out of the bottle. Lots and lots of countries will apply the new technologies. Some of this will be gradual and largely unnoticed outside the industry. More will be got from existing conventional reserves, and gradually new reserves will be opened up. There is no shortage of shale reserves around the world.

It is highly likely there are substantial shale reserves. But at what price point cost-wise do they make sense to develop? And what about pollution costs and environmental cleanup?

All of this has come together now in the perfect storm for oil producers.

Innovation

People keep asking me “where will the jobs come from?” And I keep responding along the lines “I don’t know, but innovation creates jobs over the long haul”.

Right now we are in a “creative destruction” phase where the internet created massive numbers of jobs, but now seems to be taking them away. But what about the future?

Helm has some ideas.

For many bright young researchers in the universities, their commitment to develop new low carbon energy supplies is a further source of optimism about technical progress, and their motivation is exogenous to price. It is the one bit where the market’s reach is limited. The likely product of this research is very large, and indeed is already producing a bewildering number of options and opportunities.

His thesis on energy (and mine on jobs) needs to happen before we blow ourselves up over trade wars, currency wars, energy wars, and religious wars.

Winners and Losers

The winners in this oil selloff are generally oil importers. The losers are the exporters.

The Financial Times has this interesting graphic of Winners and Losers of Oil Price Plunge.

Big Winners

From the above graphic it would appear that Europe is the big winner.

Falling oil prices enable producers to pass on lower prices for the benefit of consumers and producers alike. One would never know for all the European bitching and moaning over price deflation.

Nonetheless, the biggest winner in all of this is Japan, not Europe. Falling oil prices are the one thing that has saved Abenomics from complete disaster.

Big Losers

The biggest losers are easy enough to identify, but the chart has it wrong as Saudi Arabia.

Arguably the two countries most punished by falling oil are Russia and Venezuela. The latter I expect to default sometime in 2015.

The Financial Times notes one of the ironies in this mess. “As late as October, a ‘key concern’ of the International Monetary Fund was the risk of an oil price spike caused by geopolitical tensions. Instead, rising production and weaker demand growth have left suppliers competing to find willing customers.“

As usual, the IMF worries about the wrong things with a perpetually overoptimistic view of the global economy.

Central Banks Enter the Fray

I commented on the Russia impact in Moscow Hikes Interest Rates to 17% from 10.5% in Emergency Middle-of-Night Action.

Bloomberg chimed in on the winners and losers debate with Oil Spilling Over Into Central Bank Policy as Fed Enters Fray.

Norway’s central bank stunned investors last week by cutting its main interest rate to head off a “severe downturn” due to plunging oil prices. Ninety minutes later, Russia’s central bank raised its benchmark to bolster a currency weakened by crude’s decline. The split among two of the largest oil exporters shows how the slump in the price of crude to its lowest in five years will make 2015 a year of divergence for global central banks and increased volatility in financial markets. The U.S. Federal Reserve enters the fray this week. Some economists expect it to drop the commitment to hold rates near zero for a “considerable time.” Hiring is accelerating and officials including Vice Chairman Stanley Fischer have emphasized the boost to consumer demand from oil’s decline. Cheaper oil “lends support to our expectation of monetary-policy divergence next year, making Fed tightening in the first half more likely, while pushing other central bankers to be relatively more dovish,” Credit Suisse Group AG economists led by Neville Hill and James Sweeney said in a Dec. 12 report to clients.

Boon to Spending or Recessionary?

As noted above Credit Suisse Group AG economists think cheaper oil will make “Fed tightening in the first half more likely.“

I propose it’s not that simple. Indeed, I am willing to take the other side of the bet, in line with the Reuters article Early Slowdown Signs Emerge for U.S. Oil States After Crude Slide.

After leading the U.S. economic recovery out of recession, some of the nation’s top oil states are showing early signs of a slowdown as a result of the plunge in crude prices. In Houston, Texas, the first oil industry layoffs have been announced, with realtors there predicting a sharp decline, up to 12 percent, in home sales next year. Alaska’s 2015 fiscal year budget revenue forecast will have to be lowered by almost $2 billion, according to Fitch Ratings, because of the sharp drop in the state’s forecast crude prices. That will widen Alaska’s budget gap to almost $3.4 billion, Fitch said in a Dec. 11 report. States such as Texas, North Dakota, Alaska, Oklahoma and New Mexico are all likely to feel strains next year, Wells Fargo Securities municipal analyst Roy Eappen said in a recent report. Meanwhile, household sentiment in Texas, Louisiana, Oklahoma and Arkansas where memories of the catastrophic 1980s oil crash are still fresh, weakened in October more than any other region, according to a report by Decision Analyst Inc. The Texas-based research company surveys monthly thousands of homeowners in the Census Bureau’s nine regional divisions. The West South Central division, comprising those four states, had seen the strongest growth for four years, but in October survey lagged the rest of the nation, with economic gauges improving in six regions and two recording no change.

That’s a lot of weakness. And given the Fed responds to stock market declines with dovish statements, the Fed just may have its hands tied in 2015.

Watch Junk Bonds!

Junk bonds, especially energy junk bonds have been crushed lately as I noted on December 11, in $550 Billion Energy Junk Bond Bubble Busts; “Whac-A-Mole” Distortions in Multiple Markets.

If energy prices decline, expect a spillover into all junk bonds. In fact, junk bonds are also at huge risk if the Fed tightens. And if Credit goes, speculative stocks will follow.

It will not take much to push the economy over the edge. Yes, I have said that for some time. And no it has not happened yet.

But every delay of the inevitable pushed asset prices higher and higher. Equity prices are currently more richly priced than any time in history with the exception of 1929 and the 2000 tech bubble.

Stocks are a sell on their own accord. The energy shakedown, currency volatility in numerous countries, a slowdown in China, numerous Eurozone problems, and bubbles in bonds and equities do not bode well for 2015.

Images: Flickr (licence attribution)

About The Author

Mike Shedlock / Mish is a registered investment advisor representative for SitkaPacific Capital Management. Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction. Visit Sitka Pacific’s Account Management Page to learn more about wealth management and capital preservation strategies of Sitka Pacific.

You are currently viewing my global economics blog which typically has commentary every day of the week. I am also a contributing “professor” on Minyanville, a community site focused on economic and financial education. Every Thursday I do a podcast on HoweStreet and on an ad hoc basis contribute to many other sites.

When not writing about stocks or the economy I spend a great deal of time on photography and in the garden. I have over 80 magazine and book cover credits. Some of my Wisconsin and gardening images can be seen at MichaelShedlock.com