Revisiting an article originally published 12.16.14
Oil prices dropped dramatically in the second half of 2014. The supply and demand imbalance pressured the price to drop almost 50% in the 6 months between June and December. At the time, we discussed OPEC’s decision not to cut production which continued to saturate an already over-supplied market. OPEC believed U.S. producers would not be sustainable at the lower price of oil. By enduring some short-term pain, OPEC reasoned they would be able to retain market share and position themselves to benefit from an anticipated rebound in price.
How has this played out?
Oil followed a steady decline to a low of $43.46 in March of 2015. It seemed like a “bottom” had formed as oil rebounded, hitting $61.43 in June. However, the market reverted back to the fundamentals of an oversupplied condition, dropping 44% over the remaining two quarters of 2015 to settle at $31.29 as of this morning. What’s more, Morgan Stanley, Bank of America, and others project oil reaching $20 in the next 6 months.
The low price of oil has affected the major producers. Saudi Arabia, the largest member of OPEC, has increased the price of gasoline in their own country by 50% (the government’s main source of revenue is oil) because they can no longer sustain government subsidies. Meanwhile, in the United States, oil production peaked in April 2015 and has been declining since. In fact, many producers are teetering on the brink of bankruptcy. However, while U.S. production is declining, it remains at levels last seen in the 1970s and is contributing to the oversupplied global market.
OPEC is continuing with their strategy to keep production high in order to retain market share and force out the U.S. producers unequipped to operate at such low margins. The tremendous growth in production since 2008 has and will continue to decline as more and more U.S. producers feel the pressure of low oil prices. In fact, OPEC recently stated that weakening supply growth outside of OPEC will cause oil to reach $80 per barrel by 2020.
The logical assumption that demand will increase in the face of lower prices is currently being met with fears of the Chinese economy slowing at a significant pace. A slowdown in China can have a major impact on global demand as China is the third largest consumer of oil, behind North America and Europe. Oil consumption in North America was flat between 2010 and 2013 and Europe’s consumption dropped 7% during that same period. The spotlight is on China because it consumed 17% more oil in 2013 than it did in 2010. If consumption in China flattens out, global demand weakness will be very real.
In 2016, supply will continue to outpace demand and the price of oil will continue its downward slide until some equilibrium is reached. Long-term, the price of oil will rebound; it’s just a question of when. The recovery may be a bumpy ride as higher prices will allow high-cost producers to jump back into the game – increasing supply and lowering prices.
Impact on Natural Gas and Power Procurement
The price of natural gas and electricity generally do not correlate to the price of oil.
For the most part, natural gas is driven by domestic factors while oil is an international commodity. Like oil after the shale revolution, natural gas has seen a dramatic influx of supply since 2008. The oversupply and low cost of natural gas caused pipelines to be rapidly developed and, as of April 2015, natural gas has become the most used source for electricity in the United States, surpassing coal. The demand story for natural gas is much different than oil because there’s a clear trajectory for increased demand in electricity generation.
As the price of oil does not directly impact the price of natural gas, we also can say it does not directly impact the price of electricity. Cheap natural gas currently generates much of the electricity in the United States, keeping the price of electricity down. Electricity rates, however, are comprised of additional components independent of the fuel source, mostly dedicated to maintaining grid reliability, which tend to increase over time.