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COMMENTARY

Oil gets caught in a perfect storm

DEMAND uncertainty, high production and scepticism about the Organization of Petroleum Exporting Countries' resolve to curb output have come together to drive oil prices sharply lower. This perfect storm is raising questions about both short- and long-term price stability, placing even greater pressure on many of the top non-US producers that are set to meet in Vienna on Dec 3.

To better understand what's ahead, market participants would be well advised to draw insights from what economists call the "cobweb theorem", an economic model that helps explains price dynamics.  

Last week, oil prices fell 10 per cent in volatile trading that was amplified by signs of frantic repositioning by some market participants. The price for the WTI blend has plummeted by one-third in less than two months, to US $50 at the end of last week from a high of US$76 on Oct 3. Some analysts are warning that the market may even be repeating the pattern of a few years ago, when oil prices collapsed by more than half, from close to US$90 in November 2014 to just $41 in January 2016.

Three distinct factors have driven the recent price retreat, which occurred despite further US sanctions on Iran that limit that country's ability to export oil:

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Market voices on:

  • More evidence of a weakening global economy, including disappointing data from Europe and mounting concerns about China's economic well-being.
  • Confirmation that US production is booming, including a doubling in shale production since 2012. 
  • Repeated calls by President Donald Trump for Saudi Arabia to avoid any actions that would result in higher oil prices.

Saudi Arabia recently signalled its interest in leading a new effort to stabilise prices by cutting its own output as part of a more general reduction that would involve both Opec and non-Opec producers (notably Russia). But many market participants believe the likelihood of translating this into effective action has been diminished by political developments.

Difficult short-term outlook

Mr Trump has waged a Twitter campaign calling not just for lower oil prices overall but also for Saudi Arabia specifically to avoid any action that would block the downward trend. The credibility of Mr Trump's efforts has been enhanced by his decision to refrain from taking action against Saudi Arabia over the assassination of the journalist Jamal Khashoggi. Now that they've received a pass from Mr Trump, it would be hard to envision top Saudi officials taking explicit action to raise oil prices.

All of this translates into a difficult short-term outlook for oil prices. In addition to the lack of support from both demand and supply fundamentals, the market has to navigate the weakening of another stabilisation anchor: Opec's coordination with Russia and some other producers to balance output and current use at higher prices. These developments also point to trickier longer-term prospects, confirming a change in an important aspect of where and how the role of swing producer is pursued.

After trying a hands-off approach at the end of 2014 and retreating from leading Opec's swing producer function, Saudi Arabia resumed its traditional leadership position two years later but with some operational changes that increased the short-term effectiveness of this price-stabilisation role. These modifications included greater coordination with Russia and some other non-Opec producers, and greater flexibility within Opec. Yet the oil cartel's very position as swing producer is challenged by the increasing influence of the US.

Large swings over a typical price cycle

With its higher production and more vocal views on prices, the US has increasingly been asserting its role as another de facto swing producer for the oil market, thereby diluting the traditional role of Opec. And unlike Opec, an important part of America's role - currently assumed by private sector shale production, and lacking public sector direction or intervention - is being pursued differently, suggesting large swings over a typical price cycle. Remember, shale production and investment tend to react to price changes with a longer time lag (though it has shortened somewhat in recent years).

To grasp the resulting price dynamics, oil market participants should acquaint themselves with insights from the cobweb theorem, an approach that was once very popular for explaining price movements in the commodity sector, particularly agriculture.

Simply put, the theorem incorporates lags in assessing how producers' output decisions respond to price developments, highlighting why price may not converge to its demand/supply-determined equilibrium level in an orderly and timely fashion. Not only does it take time to spiral in toward the equilibrium price level but, in some instances, it can spiral out for a period, resulting in wild price fluctuations and some potential breakages for both suppliers and consumers.

The implications of last week's sharp decline in oil prices go beyond the usual range of economic and market influences. The fall also provides an insight into the gradual structural changes experienced by a market that plays an important role in a wide range of production, investment and consumption decisions. BLOOMBERG