Falling Oil Prices: Past, Present and Future - Kent Bartell, CFA
←
→
Page content transcription
If your browser does not render page correctly, please read the page content below
March 2015 Falling Oil Prices: Past, Present and Future Kent Bartell, CFA®
Falling Oil Prices:
Past, Present and Future
The surprise drop in oil prices was the biggest economic story of 2014. After years
of $100 barrels of oil, the price plummeted by roughly half during the second half of
the year. This was a stunning turn of events for U.S. consumers, who had become
accustomed to paying $4 for a gallon of gasoline.
The economic implications are significant. Despite efforts to develop alternative sources
of energy, oil is the world’s primary commercial energy source and will likely remain
so for decades to come. Historically, since World War II, the strongest bursts of global
economic growth have coincided with relatively cheap oil. Likewise, high oil prices have
[Photo of
often brought economic stagnation and at times even spurred a recession.
author, if
available] The correlation of low oil prices and economic growth combined with recent price
volatility have caused many to ask, “What will oil prices do next?” While no one has a
definitive answer, this paper explores the possibilities over the upcoming years as well
Kent Bartell, CFA® as the likely impact on the U.S. economy and investments.
kent.bartell@standard.com
www.stancorpadvisers.com
The recent price decline should not be viewed as a solitary event; rather it is a
continuation of a power struggle between oil producers and consumers that has lasted
for more than 50 years. With that in mind, let’s explore oil’s past.
About Kent Bartell
Kent has more than 20 years of
Oil’s Past
experience in portfolio management Humans have been extracting oil from the ground for most of recorded history, primarily
and financial services. Kent specializes for kerosene lighting and construction purposes. In fact, asphalt was used more than
in the analysis of individual equities 4,000 years ago for the construction of the walls and towers of ancient Babylon.
for client portfolios and has expertise
in defined benefit pension plans. In While oil retained its value for lighting and construction for thousands of years, usage
addition to holding the Chartered surged after the invention and popularization of the internal combustion engine in the
Financial Analyst® and Associate of the late 1800s. Oil’s importance as a commercial asset grew, and it became increasingly
Society of Actuaries designations, Kent important politically as it provided a strategic advantage to nations with access to the
is an Enrolled Actuary. He graduated commodity. Prior to World War II, Japan’s incursion into the Asian mainland was driven
from the University of Michigan with primarily by their need for oil and other natural resources. Likewise, the surprise German
bachelor’s and master’s degrees in invasion of the Soviet Union during World War II was at least in part to secure enough oil
business administration. to keep Nazi tanks running and bombers in the air.
Following World War II, consumption continued to increase as oil was needed for the
rebuilding of Europe as well as to fuel the rapidly expanding U.S. economy. Commercial
aviation, increased use of plastics, much of the middle class moving to the suburbs
and the explosive growth of the automobile industry resulted in a seemingly insatiable
demand for the substance. Domestic oil consumption spiked from roughly 5.8 million
barrels per day just after the war’s end in 1949 to over 14.7 million barrels per day by
1970, according to estimates by the Energy Information Administration (EIA).
But while U.S. consumption skyrocketed, U.S. production failed to keep pace. In
1949, the U.S. produced most of what it consumed, but that didn’t last for long. U.S.
production peaked at just over 9.6 million barrels per day in 1970, forcing the U.S. to rely
on imports to make up the steadily increasing supply gap — a gap that became larger
and larger as time went on.
Saudi Arabia quickly took over as the largest producer in the world, leading to riches
unimagined by that country merely decades before. However, the Saudis, as well as
the other predominately Middle Eastern exporters, found they had little control over the
price. The market at the time was dominated by a handful of multinational corporations,
collectively known as the “Seven Sisters” that colluded with each other to dictate
Falling Oil Prices: pricing. In response, Saudi Arabia helped found the Organization of Petroleum Exporting
Past, Present and Future Countries (OPEC) as a competing power in 1960. OPEC’s stated aim was to ensure a
minimum price for each barrel of oil.
March 2015
The economic turmoil
caused by the oil embargo
of the 1970s caused the U.S.
and its Western allies to
turn to alternative energy
sources in an effort to
wean themselves from their
dependence on OPEC’s
imports.
Source: U.S. Energy Information Administration
Throughout the 1960s, OPEC was primarily successful in their mission and the price of
oil did not change much. All told, the average per barrel cost of oil barely budged from
$2.77 in 1949 to $3.39 in 1970, according to Plains All American and Inflationdata.com.
However, OPEC’s power grew significantly after U.S. production peaked in 1970. As
OPEC’s share of total world production increased, the organization shifted from a
primarily defensive stance to a more aggressive one. In 1973, OPEC declared an oil
embargo in response to the Western support of Israel in the Yom Kippur War. The result
was a sharp spike in oil prices from roughly $3 to $12 per barrel, leading to consumer
panic in the U.S. and a subsequent global recession.
OPEC realized oil could be used as an economic weapon. For the remainder of the
1970s, OPEC used this newfound weapon often. Global demand was so great that they
could achieve significant price increases whenever desired merely by withholding a
small amount of production from the market. As a result, the 1970s saw near-constant
increases in oil prices. The decade closed with an average oil price of $37.42 per barrel
— more than eleven times the price just ten years before.
The economic turmoil caused by the oil embargo of the 1970s caused the U.S. and its
Western allies to turn to alternative energy sources in an effort to wean themselves from
their dependence on OPEC’s imports. Industrial nations increasingly used other energy
sources such as coal, gas and nuclear power. Vast research budgets were devoted to
the development of renewable energy sources such as wind and solar, as well as new
domestic oil production methods like deep water drilling and hydraulic fracturing. As
global supply increased and demand decreased, oil prices dropped. This steady decline
lasted for the next 18 years, until around 1999.
Then, the balance of power tipped again. While oil consumption in the developed world
is still generally flat or declining, emerging markets such as China have been picking
up the slack, and more. Once again, global supply struggled to keep up with demand.
Except for briefly during the 2008-2009 global financial crisis, OPEC reasserted their
pricing power, driving prices up — at least until 2014.
Era Power Avg. Annual Reason
Price Change
1949 - 1972 Consumers +1.1% Seven Sisters dictate price
1973 - 1980 OPEC +34.3% OPEC capitalizes on supply shortage
1981 - 1998 Consumers -6.3% Developed nations cut dependence
1999 - 2013 OPEC +14.5% Increased demand from global growth
Falling Oil Prices:
Past, Present and Future 2014 - ? Consumers?
March 2015 Source: Plains All American, InflationData.com. Average annual price change per barrel of Illinois Crude.
The Present
The oil situation of today is similar to the end of the last OPEC era. Once again, high
oil prices have diminished global demand. While U.S. oil consumption peaked in 2005,
it has, for the most part, slowly declined since. The U.S. has renewed its commitment
to renewable energy sources, and these new sources have significantly contributed to
supply. Furthermore, technological innovations have unlocked domestic resources that
were previously uneconomical to develop. Deep water drillers are penetrating deeper, oil
sands are being developed, and new horizontal drilling techniques combined with better
hydraulic fracturing methods have resulted in a shale energy boom.
Seemingly, new oil projects come on line every month. After decades of slow decline,
only a few years were needed to regain monthly domestic oil production near the 1970
peak.
Source: U.S. Energy Information Administration
OPEC Response
From OPEC’s perspective, the increase in U.S. production has been alarming. Not only
is the U.S. adding new capacity nearly every month, but the pace of production increase
is accelerating as well. Additionally, OPEC fears other parts of the world might develop
oil producing capabilities using the same technologies.
With this as a backdrop, OPEC held a meeting in Nov., 2014. At that time, oil prices had
already slid approximately 20 percent. Analysts expected OPEC to cut production in
order to maintain high prices, which would have been consistent with their policy over
the prior three years. Instead, OPEC shocked markets by announcing that there would
be no production cuts, allowing the market to correct itself. Oil prices, which had been
in an orderly decline until that point, went into free fall for the rest of the year.
On the surface, some might think OPEC’s decision did not make financial sense. In
fact, the decision was not unanimous among OPEC members. Poorer OPEC member
states such as Venezuela, Iran, and Algeria argued — and still continue to argue — for
production cuts. However, Saudi Arabia has blocked their appeals. While it is possible
that the Saudis will eventually be won over, that is not expected any time soon for three
primary reasons.
First, Saudi Arabia has been unable to depend on other OPEC member nations to stay
below their production quotas. In fact, a recent study by Brown University professor Jeff
Colgan found that OPEC members pumped more than their permitted quota 96 percent
of the time. The Saudis would likely take the brunt of any overall production cuts.
Falling Oil Prices:
Past, Present and Future Second, while production cuts would undoubtedly increase profits in the short run,
Saudi Arabia is taking a long-term perspective. New shale drilling projects are only
March 2015profitable if oil prices remain in the $50 to $100 per barrel range, according to EIA
estimates. Recently, Goldman Sachs evaluated the largest 400 projects throughout the
world and concluded that fewer than one-third would be profitable at current prices.
By forcing lower oil prices, Saudi Arabia can eliminate these projects and protect their
market share over the long term.
Third, Saudi Arabia’s political motivations should not be discounted. Sectarian tensions
between the Shiite and Sunnis have been high, as Iran, which is primarily Shiite, and
We expect continued Saudi Arabia, primarily Sunni, have engaged in proxy conflicts throughout the region
oil price volatility in the for the past few years. Crippling Iran’s economy with lower oil prices can remove the
short run. For the long country’s ability to support neighbors in the region combatting Saudi-funded insurgent
groups.
term, whether the market
ultimately settles at $30, The Future
at $70, or somewhere in We believe a sudden rebound in oil prices to $90 or $100 per barrel in the near future is
between, we expect these highly doubtful. Even if OPEC decided to take action to push prices back up — and was
relatively low prices to be successful — higher prices would probably be short lived considering the vast quantities
of additional supply which would then be accessible at the higher price point.
maintained for years to
come. However, we do expect continued oil price volatility in the short run as the market
struggles to determine where prices will ultimately settle. Some analysts think that prices
could dip below $30, although it is unlikely such a low price would last long. At that cost,
the supply would shrink below global demand. Other analysts predict a partial recovery
to more than $70, but that is similarly unlikely because it would require OPEC fortitude
that has not been seen in the last few decades.
Looking at the Oil Price Eras chart, history shows that when the oil dynamic has shifted,
the new trend has tended to last for years, if not decades. So whether the market
ultimately settles at $30, at $70, or somewhere in between, we expect these relatively
low prices to be maintained for years to come.
Impact on U.S. Economy and Investments
Assuming we are correct, the first economic casualty will be the current U.S. shale
boom. It might be tempting to conclude that low oil prices are bad for the economy,
given that shale has been a significant part of gross domestic product growth over the
past few years. That would be true if the shale boom was the only factor affected.
When looking at the overall U.S. economy, lower oil prices also have a positive impact.
Despite calls for energy independence, the U.S. still unequivocally remains an importer
of oil. The U.S. economy is consumer-based and lower oil prices means lower gas
prices, which directly benefits U.S. consumers. And this consumer effect is immediate.
It is estimated that every one dollar drop in the price of gas leads to an immediate one
percent increase in consumer spending. If oil is a tax on economic growth, the U.S.
consumer is experiencing a significant “tax cut.”
While there certainly will be turmoil in the shale business, the U.S. is blessed with an
incredibly flexible economy capable of adjusting to problems in any one sector. Jobs will
be lost in the oil patch, but they will likely be replaced elsewhere in the U.S. economy. If
cheap oil has returned for the duration, it could ignite significant growth for the U.S.
Additionally, sectors that find oil to be a significant cost of doing business are
positively affected by lower oil prices. This means manufacturing and transportation
sectors should do well for years to come, especially airlines and trucking. Automobile
manufacturers may also thrive as less gas-efficient trucks and SUVs — autos that offer
higher profit margins — become more attractive to consumers. Likewise, retailers who
cater to the middle class may see the greatest boost as more discretionary money is
spent on goods rather than gas.
Conversely, the energy sector will experience the greatest pressure — specifically
alternative energy developers reliant on being a cost-efficient substitute for oil. Industries
that are dependent on the steady stream of new oil projects might also struggle, such
Falling Oil Prices: as drillers and exploration companies. Some regional banks heavy in loans to fund oil
Past, Present and Future projects could encounter trouble too, if those projects wind up in bankruptcy.
March 2015It is also true that low oil prices contribute to low inflation. If deflation fears surface, it
is possible that the Federal Reserve (Fed) may delay raising interest rates. While most
economists expect the Fed to raise rates in 2015, it could be postponed to as late as
2016 if inflation remains benign.
With low oil prices changing inflation expectations, the bond market will be affected
as well. Bonds rallied during the recent oil price drop and should continue to perform
well if oil prices stay low. However, this is true for only high quality holdings. Some junk
bonds could suffer if the issuing companies borrowed too much money assuming that
profitable oil-related projects would allow them to meet debt obligations.
From a global perspective, other oil dependent nations should receive an economic
boost. Low oil prices could be the impetus to finally pull Europe out of economic
doldrums. Emerging market countries that also heavily consume oil should benefit too,
such as India and China. Other emerging market countries, such as Brazil and Russia,
who produce oil will likely struggle.
Summary
We believe the balance of power between OPEC and consumers has now shifted and
relatively low oil prices will be maintained for at least the next few years, if not decades.
If history is any guide, we expect this to have a positive impact on global economic
growth for years to come.
Falling Oil Prices:
Past, Present and Future
March 2015About StanCorp Investment Advisers Helping you achieve lifelong financial well-being is the primary focus of StanCorp Investment Advisers, Inc. We have a fiduciary duty to act in your best interest and adhere to a prudent, unbiased approach to managing your money. Our asset management process starts with learning about you and your goals. Your advisor will recommend a portfolio structure that invests your assets according to your specific time frame. We go beyond your portfolio to take a comprehensive look at all aspects of your financial life and provide guidance to set you on a path to financial well-being. 800.378.5742 www.stancorpadvisers.com Falling Oil Prices: Past, Present and Future © 2015 StanCorp Investment Advisers, Inc. All rights reserved.
You can also read
