The Curious Case of Oil Prices

The Curious Case of Oil Prices

by Mustafa Mustansir, FIFC

The international price of WTI Crude at the close of June 2014 was $105.93 per barrel. Since July 2014, the same has plummeted to $57.81 per barrel as at 12 December 2014-an approximately 45% decrease, and expected to reach $55 by the end of the year. The effect of such a drastic fall around the world has been a noticeable fall in fuel and utility prices, which can be extended to add falling travel fares, and even falling prices of consumer goods. Further on the upside, inflation is set to remain low or even enter the negative, signalling an increase in the living standards as the purchasing power of money will retain itself for longer or even increase.

On the downside, the sharp decline in oil prices has pushed countries heavily dependent on oil exports in to a developing recession. These include Russia, Iran, and Venezuela. All three are already under pressure owing to international sanctions for various geo-political and foreign policy reasons and rely heavily on oil exports with high oil prices to meet their needs.

The falling prices have also hit businesses involved in the exploration, extraction and marketing of oil. Companies entered into long-term borrowing contracts for exploration and extraction of oil in order to meet high price pressures are now at the losing side of billions of dollars. Margins for marketing companies have also fallen owing to regulation pushing prices of fuel downwards in almost every country of the world.

           

So what has caused such a sharp decline in oil prices in such a short period? The answers may be two.

Firstly, a similar decline in oil prices was noted in 2008 when the price of oil fell from $147 per barrel in the month of July to $46.44 at the close of the year-an approximately 68% decrease. A decrease greater than 2014 and in even lesser the time. Speculation was at the heart of it!

According to data and expert insight, the major reason for such a tumble was the outright liquidation of oil on part of institutional investors around the world. It is asserted that the surge in price of oil in the earlier part of 2008 was a result of long positions in oil for several major investment banks around the world as they anticipated to cash out with rising prices of oil in future by buying for less and selling for more. The same was also a part of the strategy to hedge against inflation for several major hedge-funds.

However, by mid-2008, the sub-prime mortgage crisis in the US had exploded out of control. For those anticipating a decrease in oil prices owing to the looming burst of the real estate bubble, were massively short on oil since the close of 2007. In the period of higher prices of oil, the same investors were repeatedly called by exchanges to deposit more cash to meet collateral requirements because their bets had turned unfavourable. Unable to raise more capital they were forced into selling their future positions. This sent the first signals of halt in the surge of oil prices, as a couple of big players even went into bankruptcy unable to meet the collateral needs.

Side by side, stock prices also plunged amidst rumours of stimulus packages in major world economies surfacing the media. An international recession was knocking at the door. This meant that dollar became favourable and so started to gain value as the crisis had now grown international. Now as oil is traded in dollars, a stronger dollar meant more oil could be bought for less and hence, the price of oil began to fall.

Speculative investors with long positions were called by the exchanges to put up more margin as the price of oil fell. But because they were facing liquidity pressures as their other investments were losing value too, and the banks were reluctant to lend facing liquidity crisis themselves, all the investors were forced to liquidate their future positions. Most of these positions were already highly-leveraged, which meant that prices of other assets also went down when these positions were deleveraged.

The result was a chain reaction, where the more the investors scrambled to deleverage and liquidate their positions and the more it sent the price of oil downwards. Money was disappearing in oil and investors willing to maintain long positions faced a credit crisis as banks remained reluctant to lend to help them meet margin requirements.

Fast-forward to 2014, the reasons for declining oil prices are far from speculative. One reason for the decline is the surplus supply of oil compared to its demand. The USA became the third largest oil producing country in the world during 2014 with more and more shale reserves being discovered every day. Supply of oil from crisis laden oil exporting countries like Iraq and Libya has also remained stable despite the conflict, with others like Russia, Venezuela and Iran heavily relying on exporting more of it to finance their economies owing to international sanctions.

Moreover, demand on the other hand has remained flat and even declined owing to a slowdown in China, and the EU. China has been noted to contribute the most to any increase in demand for oil over the last decade and clearly so, a fall in demand of oil from China has contributed to a fall in oil prices as well. Exploration of more oil in the US has also resulted in a decline in US imports of oil although the US is not exporting any oil at the moment.  

To add more to it, the Organisation of Petroleum Exporting Countries (OPEC), which controls 40% of the supply of global oil, has also failed to reach an agreement to curb supply to support a rise in prices in its recent meeting on 27 November, in Vienna. Another interesting face to it is the growing shift towards other alternative and efficient sources of fuel in major economies of the world. However, the extent of their hitting the demand of oil is difficult to measure precisely.

As for speculation, the mood is mixed. However, the current global macro-economic landscape is favourable for a short position. Undoubtedly, major players have already made record gains in betting on put options for oil over the last five months as reported by Bloomberg Businessweek. Although, Oil-Price.net has forecasted oil to reach $66 per barrel in the next twelve months.

Conclusion:

Global oil prices are affected by more than simply the forces of demand and supply. The current decline may be cyclical. It may also be artificial to serve geo-political interests because it hurts countries like Russia, Iran and Venezuela the most. It may also be due to the gradual shift towards alternative sources of fuel. But in the past, prices of oil have been subject to significant ups and downs owing to speculation and panic among institutional investors as well. Historically they have been self-correcting.

Among other things, the current situation also indicates that although falling oil prices will benefit export-oriented economies like China and the EU, the consequent increase in their already huge trade surpluses may trigger macroeconomic imbalances around the world. With the EU having almost zero inflation, the fall in oil prices may send deflationary pressures to their contracting economies. This means that countries with heavy borrowings like the US and the UK, will have to borrow more or print more money in order to finance more stimulus packages to fight these deflationary pressures. Consequently, triggering another global recession.

  

The writer is a Fellow of the Institute of Financial Consultants Canada & the USA, a member of the Royal Economic Society UK, the American Finance Association USA, and the Head Consultant and Chief Economist at Volkerak Financial Consultants.

You can find him on Twitter Mustafa Mustansir or mustafa.mustansir@volkerak.com