Oil Market Mismatch Between Supply and Demand – 1/10/16

With a possible IPO of Saudi Aramco in the works, headlines are trumpeting the magnitude of the company’s value to the oil market. Valuations estimate assets including trillions of dollars worth of oil reserves – even in a time when prices are at decade lows and expected to go lower – would put the company’s value higher than Apple or Exxon or any two others combined… without accounting for risk. The reality of the situation is much less exciting. Like Iran and Venezuela, Saudi Arabia nationalized the foreign-owned oil production assets in the 1970’s as prices were reaching highs. The risk of nationalization without compensation will, as it should, make investors hesitant to buy into any stock the company might put out since the end result would be much the same as a default where there is no possible recourse. The main difference between the two situations being that the government is more likely to cut out investors just as prices and profits are rising. In the face of such a risk, a significant discount will likely be worked in.

Oil prices continue to fall as the usual remedies for mismatched supply and demand are no where in sight.

On the supply side: no one is willing to cut production and the dollar is set to strengthen.

OPEC has been faced with a shrinking market share as high prices made economical the high-cost production methods such as fracking, tar sand extraction, and ultra-deep water rigs. The cartel, which produces over 40% of the world supply, has reduced output in the past to send prices upward but currently refuses to move away from current levels. Why? Because market share is still an issue.

The shale-oil boom has defied expectations by OPEC that high prices would strangle the fledgling industry, and it appears to be here to stay as improved efficiency keeps costs falling and financing proves surprisingly forthcoming. And with the lifting of sanctions against Iran not far off, the country is keen to increase production as much as possible even at the expense of fellow-OPEC members. Besides being geopolitical rivals, Iran and Saudi Arabia will be squaring off with new fervor in the global oil markets. Meanwhile, Russia continues to pump for revenue maximization pointing out that it has no interest in OPEC’s attempts to kill off US production through price manipulation. For their part, the high-cost producers in the US are holding on for dear life as each tries to be one of the lucky survivors once the rebound hits and they get a chance to take up more market share from whoever cuts production first.

Oil is leveraged heavily on the dollar, and as the dollar strengthens, oil prices fall. The dollar has finally finished struggling against other currencies that has characterized it since the financial crisis. Now that the US economy appears to be gaining some momentum while others are losing steam, the dollar may drive the price of oil down as low as $20 a barrel. Diversification seems to have saved the US from the slump that many will face now that China is beginning to slow its consumption of foreign commodities. Countries reliant on oil for rosy economic numbers such as Russia, Brazil, and Canada are seeing large devaluations in their currencies. In Europe, overall anemic growth, the Greece-Eurozone issue, and the migrant crisis have made for a sour mood on the Euro.  China is also likely to see a weakening yuan as the falls on pessimistic expectations for the countries economic future.

On the demand side: China’s growth slowdown and pushes for greater fuel efficiency make for bleak short-term and long-term demand expectations.

For years, China has been the driver of global growth as the Communist party appeared to deftly handle the economy. Many even claimed the country would become the new dominant force in the global economy. Nowadays, a very different tune is being sung. Between wild stock market swings, dodgy currency manipulation, stalled reforms of debt-burdened state companies, massive capital outflows, and a massive overcapacity problem, the reputation of the central government has taken a serious pounding. Ghost towns created by a speculative housing sector now stand as monuments to just how out-of-control the country’s drive to meet “growth” targets had gotten. Now that China is facing the reality that no economy can grow at 7% forever, all commodities it previously gorged itself on, from iron to oil, are seeing prices plummet much to the anguish of major trade partners in Asia and Australia.

With oil prices set to rebound sometime in late 2016 due to producers restricting their drilling, the panic surrounding oil is likely to be a short-term issue, but what about the long game? What will happen to oil prices as technological, environmental, and geopolitical forecasts begin to become reality? According to the EIA, about 70% of all oil used in the US goes to transportation and, with emissions and US dependence on foreign oil staying major concerns, many are working to reduce demand through autonomous and/or electricity-powered vehicles.

The Paris Climate Talks and the acceptance of the climate issue by all major countries suggest combined are turning reducing oil consumption into a major economic factor and continued unrest in the Middle East makes it national security issue. So it is no surprise that the Obama administration is beginning to put its money where its mouth is by diverting a few billion towards the autonomous vehicle industry. While Google’s efforts have been widely publicized, more interesting is the recent involvement of traditional firms in the industry. Ford is reportedly working with Google by providing the hardware to surround Google’s software systems. With millions of self-driving cars set to be on the road by 2020, the potential impact on oil could be huge if the reduction in idling traffic alone matches up with predictions.

Long years of waiting for an economically feasible electric car may soon be over as major players in the auto industry like Nissan take advantage of Tesla’s advances to build their own electric-only models. Vastly improved battery and charging technologies have made industry giants much more open to electric models. And, as the giants become more open, so too become the regulators who provide the necessary regulation and infrastructure. Given the overly optimistic predictions of the past, a conservative estimate of millions, if not tens of millions, of electric cars on the road by 2025 seems fair. And with those millions of cars that run on electricity from coal, gas, or renewable power plants, one can reasonably expect a significant drop in demand for oil for the world’s top oil consumer.

Given the way technology is going, the oil market is going to reflect a declining demand for a very long time after 2020. At that point, the next oil glut may be the one that lasts forever.

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