One of the oddities in global markets at present is the positive correlation between stocks markets in general and the oil price. As anyone who has looked at the global economy for many years would know, falling oil prices are usually good for global economic growth and stock prices. After all, falling energy costs boost the real income of households, and fatten profits margins for all the corporate that use energy within their production process.
Yet when the oil price lurches down these days, it’s taken as a signal to push equity prices lower also.
Why? Some have suggested China is to blame. At face value, a weaker oil prices suggests global energy demand is not as strong as previously thought, and given China is the largest swing energy consumer on the planet, that suggests China is in trouble.
But as I’ve argued at the Switzer Daily previously, to my mind China is being unfairly blamed for current global market woes. China is doing fine. Indeed, overall global demand for oil was quite solid last year. According to the International Energy Agency, total global oil demand reached a record 94.6 million barrels per day (mb/d) in 2015, up 1.8 mb/d on 2014 levels.
The problem is on the supply side and in particular the important new kid on the block who has muscled in on the oil production game in recent years. That’s none other than the world’s largest economy, the United States, thanks to its shale oil revolution.
According to the IEA, global oil supply rose by 2.6mb/d in 2015, marking the second successive year in which supply exceeded demand by more than 1 mb/d. Annual US crude oil production has increased by 4 mb/d since 2008, and was up 0.7 mb/d in 2015 alone to 9.4 mb/d.
The excess of supply over demand has left inventories at record highs and global oil storage capacity bursting at the seams.
The unsurprising slump in oil prices has left America’s new found industry particularly exposed. In a classic Mexican stand-off, OPEC (led by Saudi Arabia) has refused to curtail its own supply to make way for the new guy – and instead has been happy to see prices plummet in the hope of forcing America back out of the game.
Yet as seen in the chart below, the great surprise last year was that despite a slump in America’s so-called “rig count” and a sharp downturn in US investment in oil exploration and development, US oil production did not fall all that much.
US oil production peaked at 9.7 mb/d in April last year, yet according to the US Energy Information Administration it has only declined to 9.2 mb/d by December.
Why has US production remained resilient?
For starters, you don’t need rigs once a well has been drilled, and America has built up a lot of drilled wells just waiting to be “fracked” for their oil. US producers have also been able to lower the marginal cost of getting the oil out through improved technology and “learning by doing” know how. Other supports have been generous (desperate?) bankers willing to extend credit in the hope that oil market would improve, as well as savvy use of price “hedging” last year which allow many producers to at least forestall the pain of lower prices.
All that said, lower prices and the decline in oil investment and employment has killed the sector’s once boom-time conditions, which emerged as an important source of US economic growth in recent years. Indeed, as seen in chart above, mining related investment has halved over the past year – a decline worth $US80b. That alone is equal to almost 0.5% of GDP, not counting the downstream effects across other key industries such as transport, manufacturing and business services.
It’s the direct impact of oil prices on the US economy – particularly the crippled energy sector – that seems to have Wall Street most worried. Note, moreover, there’s around $US 200 billion in loans to the US shale oil industry now in jeopardy, not to mention the many more billion that have been lent to equally vulnerable energy exporting emerging markets such as Russia and Brazil. That’s why equity markets no longer rejoice when oil prices decline.
Of course, the upside of weaker oil prices is the boost to the real income of energy users. But with reduced energy intensity these days, and still fairly cautious consumers, this big pay-off has (so far at least) yet to be seen.
Heading into 2016, there’s hope that oil prices will soon bottom due to likely supply adjustments. The problem, however, is that even if this happens much of the adjustment seems likely to come from US producers – which ads to downside risks for the US economy and Wall Street. One the other hand, it’s debatable whether the US supply adjustment will be enough to stem the price slide in any case, especially in view of rising supply from Iran.
For what it’s work, America’s EIA projects US production will decline by 0.7 mb/d this year to 8.7 mb/d - which still be only back to 2014 levels. Meanwhile, the IEA estimates Iran will largely offset this US production cut back by boosting supply by 0.6 mb/d by mid-year.
Somewhat ominously, as reported in The Economist, Simon Flowers of leading energy consulting firm Wood Mackenzie said, “Even at $30 a barrel, only 6% of global production fails to cover its operating costs.” Provided firms can cover their variable costs, it’s likely they will keep producing – if only to help roll over their debts until such as the market eventually improves.
As if all this were not bad enough, the IEA concluded in its latest Oil Market Report that “the oil market faces the prospect of a third successive year when supply will exceed demand by 1.0 mb/d… unless something changes, the oil market could drown in over-supply.”