Crude oil Exploring the Past and Understanding the Factors Behind the Price Plunge

Crude Oil (Part 1)

– The Commodities superstar

If I had to choose a single international commodity that can give the same level of dramatic fluctuations as those seen in movies about stock markets, I would have to select crude oil. One need only look at the chart for proof –

The surge of crude oil prices to $140 per barrel, followed by a sharp correction before climbing back towards $110 and then an intense drop to below $30, can be likened to a thriller movie – inducing various emotions in individuals. Adding to the complexity of this international commodity is the fact that it is actively traded by hundreds of thousands of traders around the world.

To comprehend what occurred in crude oil, we must explore the recent past starting in 2014. The market saw a wild ride beginning with peaks of $115 before bottoming out at $28. What initiated this roller coaster frenzy? Where is the price currently heading? Answering these questions requires us to delve more deeply into the story of what happened over several years.

– The crisis revisited

The Brent Crude Oil has seen a sharp drop in prices, with a difference of over $110 per barrel to a low of $28 in the past five years – something that was completely unexpected. This decrease has been welcomed by some companies and nations, but has had a significant effect on oil-producing countries. There is no certainty as to how deep the fall will go, it could not be more severe than it is now, making this potentially an all-time low for these oil prices.

So what really went wrong?

To comprehend the cause of the recent crash, we must understand the workings of crude oil and the system that was in place prior to this. This serves as an overview of ‘oil basics’ for you. Countries with extensive reserves of oil produce millions of barrels each day and export them to places like The US, China, India, and Europe. Those countries can be divided into two groups –

1.     The Organization of the Petroleum Exporting Countries (OPEC) encompasses nations such as Saudi Arabia, Qatar, Kuwait and the United Arab Emirates.
2. Many nations that produce oil don’t belong to OPEC, so they are often known as “Non-OPEC countries”. Examples of these countries include Brazil, Canada, Russia, Mexico, and Norway.

Close to 90 million barrels of crude oil are produced daily from OPEC and non-OPEC countries as evident in the chart below which displays the production split.

The Trigger

Various nations create oil with varying results, dependent on their funds and current technical capabilities. The sale of oil has always been affected by the market, thus it is conceivable that the point where profits are equal to expenditures (expressed per barrel) differs from one country to another. Without a doubt, any sales below this level imply that a nation’s financial situation will not be in equilibrium.

The presence of these three key developments has had a significant impact on the business dynamics seen in the oil industry. Early 2013 saw a high cost for oil production, but since then, several occurrences have changed the face of the market. Notable among them are the growth in American shale output, OPEC’s decision to maintain steady production levels and a weaker global demand for crude. All three have contributed to lower crude prices across the board.

1.     American Shale Oil – American Shale Oil is an alternate to crude oil and has recently become technologically viable, with production costs being relatively low. This has lead to a surge in output from these sources, flooding the market with a cheaper source of oil. It is thought that The USA has enough shale oil reserves to last for generations, causing exports from OPEC members to be diverted to the US. This led to a dramatic fall in the price of crude oil across the globe.
2.     Lack of co-ordinate action – In the face of rising production of shale oil in the USA and continued decline in crude oil prices, one way for oil-producing countries to take action was to reduce supplies and create balance between supply and demand. However, OPEC failed to persuade OPEC and non-OPEC states alike to cut back on their crude output despite it being more costly than extracting oil.
3.     China Factor – China has long been one of the major purchasers of commodities such as iron ore, coal, and crude oil. In 2013, China even overtook America in oil imports. Unfortunately, with the Chinese economy now showing slower growth rates, it is having an effect on demand for international commodities – a worrying factor contributing to the fall of global oil prices.
4. Market Dynamics – Thementioned points caused crude oil prices to crash, which was compounded by the large number of short positions held in Crude Oil contracts.

Generally, a decrease in oil price will result in the US dollar becoming stronger than the currencies of emerging economies. This is quite logical, as high oil prices drive up the US current account deficit (as the US also imports oil from the Middle East), which weakens the dollar – thus there is an inverse relationship between oil and dollar strength. Taking 2008 as an example, when Oil reached $148, the US Dollar was trading at 1.6 to the EURO.

The Russian Episode

Russia is a major producer and exporter of non-OPEC oil, with its exports contributing close to 40% to total sales. Unfortunately, the slump in global crude prices has had a negative effect on the economy of the Russian Federation. Three distinct influences are adversely impacting Russia, two of which can be directly linked back to decreased oil prices.

1.     Oil Price – Russia requires the cost of oil to be around $105-107 in order to maintain its financial status; however, with the current price at $50, it has received a significant challenge for its budget.
2.     Rubble Trouble – The Russian economy is on the rise, yet the dramatic fall in oil prices has had a drastic effect on the Ruble. This resulted in the Central Bank raising interest rates drastically overnight by 7.5%, back in 2015.
3. Crimea Curse – Western countries have imposed stringent sanctions on Russia for its actions in Ukraine, cutting off access to external capital. This has proven particularly difficult for Russia when it is most needed.

The Syrian crisis, along with several other local issues, does not bode well for Russia’s economic prospects and could potentially lead to a major recession across the federation.

The India macro angle

It is evident that the reduction in crude oil prices has a positive impact on India. With two-thirds of Indian’s oil being imported, the decreased cost of imports is likely to result in a lower fiscal deficit, reduced inflation and a potential interest rate cut. All of which would be beneficial for India, particularly during this economic climate.

Even though lower oil prices reduce our import bill, they can have a negative effect on our exports. Many of India’s export markets are tied to the economies of countries that are dependent on oil, such as UAE, US, Saudi Arabia, Kuwait, Iran and China. Thus, when oil prices fall, these countries tend to tighten their purse strings which naturally affects trade with India.

If you take a look at the October 2014 import and export data from RBI, it indicates that the oil import bill had decreased by 19% year-on-year, although exports also dropped by 5%. This presents a situation where the potential benefit of lower oil prices is not as great as it seems. On 6th January 2015, we got a glimpse of what could happen if the price continues to drop when the NSE Nifty fell over 255 points, leading to significant market unrest.

Impact on the Indian Companies

State owned Oil Marketing Companies (OMC) such as HPCL, BPCL and IOC are directly benefiting from low oil prices, thus reducing stress on their working capital requirements. Over the last two years, HPCL and BPCL have retired over 50% and 30% of their short term borrowings respectively. A stabilized price of crude oil at $50 per barrel would be highly advantageous to these companies in terms of improving their balance sheets and boosting their bottom line results.

Is this the end?

It is apparent from Saudi Prince Al-Waleed Bin Talal’s statement, that if neither the supply nor the demand were to change, there is not much prospect of oil prices declining. Furthermore, the US’ repealing of its 40-year restriction on oil exports has resulted in an increase of commodity availability, consequently intensifying pricing pressure.

Undoubtedly, the American shale oil industry has had a great impact on the market. However, there are other considerations to consider: are these companies properly equipped with sufficient reserves? Are they taking on too much debt? Questions such as these will eventually be answered; and they will undoubtedly have a lasting effect on oil prices.

At this point, if I were to make a guess as to when the oil price crash might end, I wouldn’t know any better than you.

Be aware that, this one won’t contain any significant conclusions. All I did was to chronicle what actually happened to crude. Whatever we discussed today could turn out to be a negligible piece of history in the future!