Feeling the Oil Pinch

It has not been a pleasant start to the year for global financial markets. Major stock markets around the world sold off again yesterday. The MSCI global index is down about 20% off its highs and is now officially in a bear market along with the UK’s FTSE 100 and the Russel 2000 in the U.S. It’s interesting to see such a coordinated global sell off even though all the different economies around the world have vastly different dynamics and economic outlooks. There must be something fundamental connecting all the markets around the world for there to be so many bear markets at once. One reason could be due to the fact that there is no short term correlation between a country’s economy and its stock market. But that doesn’t explain the synchronized sell off of major stock markets. The real reason, I believe, is the fall of oil prices.

The West Texas Intermediate oil price is currently around $28 a barrel. It has plummeted by about 70% since the summer of 2014. This price crash is the worst one in the post-war era. The last time oil was at this price was 13 years ago back in 2003. The oil cartel made up of mostly Middle Eastern and African countries known as OPEC, continue to produce huge volumes of oil as the world tries to use up a glut of supply build up. Despite the plummeting oil price countries such as the U.S. and Canada have been doing relatively well. A lower cost of oil affects just about every facet of the economy. As a resource based economy many Canadians lost their jobs in the oil field when their employers could no longer afford to keep them employed. But on the other hand cheaper fuel prices is a boon to many other industries such as transportation. Both Canada and the U.S. economies are growing, albeit just barely.

In the short term lower oil prices does not pose a large risk to North American energy producers. Companies can still use their cash reserves and access the debt market to fund their ongoing operations even if they have no free cash flow. But the problem arises if oil stays cheap for too long and companies are forced to stop producing. After all, it costs about $36 to produce one barrel of oil in the U.S. So if the WTI price stays below $36 for an extended period of time then the economy could face some major headwinds. Many members of OPEC currently produce oil at less than $10 per barrel so they can still remain profitable even at current oil prices.

The good news for the U.S. is that the cure to cheap oil is more cheap oil. Sooner or later the supply and demand curve of oil will revert back to the average and the price of oil will climb back up. But I wouldn’t expect that to happen for awhile. According to the U.S. Energy Information Agency, Iran has the 4th largest oil reserves in the world. Analysts say that Iran already has quite a lot of oil that’s ready to sell. Since the sanctions on Iran has been recently lifted experts are expecting the oversupply of oil in the markets to continue. Manaar Energy head of consulting, Robin Mills, says, “I think Iran will return to the market as fast as they reasonably can – they need the revenues. Iran won’t return to its pre-sanctions export levels, at least not until they have received substantial new investment, taking several years. But I do expect 600,000-800,000 barrels a day extra over the course of 2016.”

The recovery of oil prices won’t happen anytime soon. Oil production is still relatively strong in the United States and other countries. There simply isn’t enough global demand for fuels to use up all the oil right now. As with any other commodity, the story of oil is one of volatile ups and downs, and we just happen to be at a major low point right now.

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