The precipitous decline in the price of oil is perhaps one of the most bearish macro developments this year. We believe we are entering a ‘new oil normal,’ where oil prices stay lower for longer. While we highlighted the risk of a near-term decline in the oil price in our July newsletter, we failed to adjust our portfolio sufficiently to reflect such a scenario. This month we identify the major implications of our revised energy thesis.
The reason oil prices started sliding in June can be explained by record growth in US production, sputtering demand from Europe and China, and an unwind of the Middle East geopolitical risk premium. The world oil market, which consumes 92 million barrels a day, currently has one million barrels more than it needs. US pumped 8.97 million barrels a day by the end of October (the highest since 1985) thanks partly to increases in shale-oil output which accounts for 5 million barrels per day. Libya’s production has recovered from 200,000 barrels a day in April to 900,000 barrels a day, while war hasn’t stopped production in Iraq and output there has risen to an all-time high level of 3.3 million barrels per day. The IMF, meanwhile, has cut its projection for global growth in 2014 for the third time this year to 3.3%. Next year, it still expects growth to pick up again, but only slightly.
Everyone believes that the oil-price decline is temporary. It is assumed that once oil prices plummet, the process is much more likely to be self-stabilizing than destabilizing. As the theory goes, once demand drops, price follows, and leveraged high-cost producers shut production. Eventually, supply falls to match demand and price stabilizes. When demand recovers, so does price, and marginal production returns to meet rising demand. Prices then stabilize at a higher level as supply and demand become more balanced. It has been well-said that: ‘In theory, there is no difference between theory and practice. But, in practice, there is.’ For the classic model to hold true in oil’s case, the market must correctly anticipate the equilibrating role of price in the presence of supply/demand imbalances.
By 2020, we see oil demand realistically rising to no more than 96 million barrels a day. North American oil consumption has been in a structural decline, whereas the European economy is expected to remain lacklustre. Risks to the Chinese economy are tilted to the downside and we find no reason to anticipate a positive growth surprise. This limits the potential for growth in oil demand and leads us to believe global oil prices will struggle to rebound to their previous levels. The International Energy Agency says we could soon hit ‘peak oil demand’, due to cheaper fuel alternatives, environmental concerns, and improving oil efficiency.
This post was published at Zero Hedge on 11/30/2014.