Tuesday, December 2, 2014

Oil Price Drop: Free Market Forces or More Chess Board Moves?

Oil prices are certainly a potential driver for monetary system change since the whole world consumes enormous amounts of oil on a daily basis. Oil prices impact just about everyone either as a buyer or a seller. Reasonable and stable oil prices are probably what's best for global financial stability and sustained growth. But in the last few years oil prices have been very volatile. Since the price of oil impacts all kinds of other goods and services and is a key revenue source for producing regions, this makes it hard for people to plan ahead. Let's look at the recent oil price drop.

This is a topic I can address from actual personal experience having worked in the oil industry (as an accountant) for over 35 years. Over that time I have seen oil prices fall as low as below $20 per barrel to as high as nearly $150 per barrel (see chart here). Whenever oil moves sharply higher or lower, there are always questions as to why the sudden sharp movement in price? Some say it's just the free market at work based solely on supply and demand. Others say that speculation in the futures market is used to manipulate the price higher or lower. Still others believe that the oil companies and OPEC set the price where ever they want to at will.

The truth is that all three of these probably come into play at various times depending on the circumstances. Certainly, OPEC has had the ability to move the price to some degree for a long time due to being the largest producers who meet  together as a cartel. If they can agree on production quotas (and actually live up to them) they can impact the price of course. But it's not really in their own interests to distort the true market price for long periods of time.

Also, in the short term, speculators in the futures markets can exxagerate normal market moves if the trade goes too heavy in one direction. But this cannot be sustained long term as futures contracts have limited life spans and have to be closed out at some point. When too many people go short at some point they will have to cover and that quickly reverses the price higher. Same thing if too many people speculate long. Most oil companies just use futures to hedge and lock in a price for some of their production. They don't speculate in futures for the most part. They just want to make sure they lock in a high enough average price to sustain operations and be able to keep investing (their product is a constantly depleting resource).

Over the long term, I believe the natural market forces still prevail for the most part. There are times when global demand rises and supply struggles to meet the demand (when economies are growing strongly worldwide). There are times when there is more supply available than demand calls for (global recessions, etc.) 

So, why has oil fallen so sharply and quickly this year? I believe that a combination of all the above is probably contributing to the dropping price. Also, due to the geo political conflicts going on right now around the world, the US might view a falling oil price as more helpful to its position. Russia, Iran, and Venezuela are all countries that get hurt by falling oil prices. Keep in mind that ISIS gets oil revenue as well.The US is in various stages of conflict with all of these right now. Therefore, it is possible that the US has encouraged Saudi Arabia (and OPEC) to stand back and let the price fall for strategic reasons. This is something we will never be able to find out about if it is true.

What we will watch here on this blog is to see if the falling oil price is due to a pullback in global GDP growth around the world (and maybe in the US too). If oil prices stay down or even keep falling, it may indicate that deflation is overwhelming the system. Falling oil prices are good for consumers, but perhaps not so good for governments and Central Banks who need inflation to deal with huge structural sovereign debt around the world. Many governments (including the US) also derive significant royalty income from oil production. In fact, this is what I work with myself in the industry. I can assure you that the US Dept. of the Interior does not get excited to see its royalty income fall sharply due to falling energy prices. They have projected budgets to meet just like everyone else.

This obviously is of interest to me because I work in the industry. It is hard to tell how this will impact the domestic US oil industry yet. If prices stay down or drop more, I think we will see the growth that has been happening drop off sharply. First, expensive new exploration plays will get suspended. Fracking (that you hear so much about) is a fairly expensive way to get oil (the wells are usually deep and expensive). Extracting oil from tar sands is out of the question at these prices. Many weaker small oil companies operate off of borrowed money which raises their break even price. Many of them will really struggle if oil prices drop below $60 for a lengthy time. This will also cause some stress on junk bond funds that are invested in these types of companies.

On the flip side, strong oil companies with low debt that can operate at a profit with lower prices per barrel can actually benefit from lower prices. This is because they may be able to buy oil and gas properties from distressed companies at bargain prices. Thankfully, I work for one of these. But I do feel for those whose jobs may be at risk with extended lower prices. That is a very scary thing to deal with and it is totally out of your control. I have seen many good people hurt by this over the years in this industry.

Large energy users like China can use lower prices to build up oil reserves as this China Daily article points out. Japan is another example. Europe might also benefit.

So there are trade offs both ways when the price falls. Over the long term though, it's in everyone's best interest for oil prices to stabilize at a price high enough to keep exploration and drilling going. Otherwise the supply starts falling pretty quickly and any uptick in global demand shoots the price back up too high. This will surprise people, but oil companies don't really want the price to get too high. It especialy hurts low income people who get higher utility bills and have to pay more for gas in their cars. No one wants that.

 Also, any kind of conflict in major oil producing areas like the Middle East can cut supply very quickly at any time. A stable, reasonable price assures us enough supply to meet energy needs as we transition over time to other alternative sources of energy like solar and wind (already growing here in Texas).

This is just another area that can impact monetary system change that we have to monitor.

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