There is a common saying that time heals almost everything. Yet, even as we embark on the fifth year since the pandemic began, most of
A New Age of Volatility for Oil
Published Date : September 17, 2015
The past few weeks have marked an extremely volatile time for energy prices. On August 21st, oil dipped below $40/barrel for the first time since February 2009 as a general risk-off mentality led to selling in addition to the ongoing concerns about oversupply and slowing demand, particularly out of key consumer China. Just a few days later, however, oil had its strongest rally in 25 years – a 30% gain in just three days. Oil volatility seems to be at record highs.
From a fundamentals standpoint, oil prices should come down to supply and demand. On the supply side, there are two primary question marks: OPEC and the US. Historically, OPEC has acted as a “swing producer,” adjusting its output when prices fell. Last year, however, OPEC changed course and did not step in when oil prices began to fall, which caused further downward pressure on prices. For OPEC, oil prices are now clearly at unsustainable levels with almost all OPEC nations needing prices significantly above current levels to balance their budgets. Saudi Arabia’s breakeven price is around $90/barrel and at current price levels, the nation could deplete their entire massive currency reserves in just 5 years.1
On the US side, we’ve seen massive pullbacks in capital spending and investment in new projects in addition to a huge drop in oil rig count.2,3 While producers are able to maintain production volumes in the short-term by increasing efficiency of their existing wells, those wells deplete exponentially in their first year of production, meaning that there is a lag effect to the cutbacks. At the end of August, we began to see this play out as the US Energy Information Administration released data showing that US production was significantly less than previously thought. Production estimates for January through May were revised downward by almost 25% to 130,000 barrels per day.4 The huge cutbacks we’ve seen from producers have started to have an effect on output.
On the demand side, one of the very large question marks remains key consumer China. China is the second biggest consumer of oil and biggest importer of oil. While China is certainly not growing as fast as it was several years ago, it is important to remember that it is growing off a much larger base. Five percent growth off of 2014 levels would add roughly $518B to global output, whereas 10% growth 10 years ago added just $194B to global output.5 That being said, concerns about Chinese growth and oil demand are justified and should be monitored closely in order to understand how oil prices will move.
While supply and demand should drive oil prices over the medium to long-term, for the short-term, prices can (and have been) quite volatile, particularly given the nature of the speculative oil market. The Oil “Paper Market” or average daily trading volume of key energy futures (excluding options and Over-The-Counter instruments) is estimated to be over 24x the amount of global oil demand. The volume of speculative trading has grown exponentially from the 1990s when this number was closer to 3x.6 Particularly in the short-term, it is not just fundamentals at play: prices can and have been driven by this much larger “Paper Market,” leading to greater price volatility and headaches for investors.
But with volatility comes opportunity, particularly the chance to take advantage of assets we feel are underpriced based on their medium or long-term fundamentals. At Sand Hill, we work to make investment decisions based on fundamentals that will help client’s portfolios over their particular time horizon.
SOURCES:
1 Cornerstone Analytics presentation, Jan. 7, 2015, p. 16
2 Financial Times, Falling prices force cutbacks and delays to exploration, Sept. 7, 2015
4 U.S. Energy Information Administration, Today in Energy, Aug. 31, 2015
5 The Economist, The Great Fall of China, August 27, 2015
6 Cornerstone Analytics presentation, August 2015, p. 1
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