Download Drilling Down the Factors Affecting Oil Prices

 Drilling Down the Factors Affecting Oil Prices
By Ismail Ghodbane, Portfolio Manager
February 2016
In late 2014, oil prices began to fall precipitously. The
descent has continued through the beginning of 2016, with
price levels reaching 12-year lows. This month, West
Texas Intermediate Crude (WTI Crude) prices fell below
$29 per barrel. Historically adhering to the rudimentary
laws of supply and demand, the energy market currently
faces an unprecedented global supply glut combined with
waning aggregate demand (stemming from slowing
economic growth and global deflationary pressures).
Moreover, technology improvements and geopolitical
undercurrents transformed the marketplace into an overly
crowded and complex environment. Attempting to
disentangle and assign specific domestic economic effects
to various global oil market forces would prove to be a
highly complicated process. However, the recent oil price
volatility does generate macroeconomic trends that may
affect U.S. monetary policy.
The energy sector - particularly oil and gas - helped
revitalize the U.S. economy in wake of the recession. The
fracking revolution brought a surge of jobs opportunities to
American workers. However, this trend is poised to reverse
as industry-wide retrenchment is expected, particularly as
oil producing companies continue to cut expenses. Over
250,000 global oil workers lost their jobs in 2015. Many
analysts expect the layoffs to worsen in 2016 as
companies face downsizing and/or bankruptcy. The Baker
Hughes North American Rig Count, which serves as an
important barometer for business activity in the oil drilling
industry, recently hit 571. Above 2,000 in 2011, the waning
rig count is now at its lowest level since 1999.
The negative impact of falling oil prices on the energy
industry was initially expected to be offset by increased
household discretionary income, ultimately bolstering
consumer spending. Unfortunately, consumer spending
remains subdued to date. More importantly, the decline in
oil prices over the past year worsened deflationary
pressures both domestically and overseas. The Core PCE
Index is the Federal Reserve’s preferred measurement of
inflation. For nearly three and a half years, the Core PCE
has trended below the 2% level on a year-over-year basis.
If inflation continues to persist at low levels through the first
half of 2016, it could be an indicator of the underlying
fragility of the economy.
Energy Price Shocks
Substantial price shocks in the energy market have
conventionally been viewed as supply disruptions, where
supply levels are out of sync with demand levels,
subsequently jolting prices. These oil price shocks have
long been the primary focus of those studying the
economic effects of energy market events, and it has long
been asserted that there are correlations between oil price
shocks and economic downturns. From 1945 to 2006, nine
of the ten recessions in the United States were preceded
by large positive increases in oil prices (Hamilton, 2005).
However, the exact relationship between the two variables
has yet to be revealed, largely due to the many intricacies
involved with attempting to isolate economic forces in such
dynamic economic circumstances.
It may prove even more difficult to dissect the
macroeconomic effects of the current price instability,
which is essentially the opposite of a supply disruption
shock. In a price decrease shock, the residual effects are
more ambiguous than a rising price shock as the situation
poses numerous offsetting effects. The Fed has asserted
that the “U.S. economic activity responds asymmetrically
to oil price shocks” (Brown, Yucel, Thompson, 2003). The
asymmetry means sharp rises in oil prices are more
detrimental to economic activity than any potential benefits
that a drop in prices may yield. However, the assumed
positive effect in this situation is increased consumer
activity due to the lower energy costs of households, which
is an outcome we have yet to see manifest. Instead,
individuals are paying down debt and increasing savings.
This consumer behavior has a suppressive effect on
inflation expectations, which is worrisome as U.S. inflation
has been stagnant for some time.
Monetary Policy
In the 1970s, exogenous oil supply shocks stemmed from
political events, such as the Oil Embargo of 1973 and the
Iranian Revolution of 1979. The Fed’s monetary policy at
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DETALUS.COM the time arguably exacerbated the macroeconomic
consequences of the oil market. Yet, rather than drawing
comparisons to historical market events, we must consider
the idiosyncratic nature of today’s energy market and its
potential influence on monetary policy. As the Fed began
its transition from an unprecedented zero rate policy to the
normalization of rates, energy price instability was one of
several deterrents that delayed the initial rate hike. Much
like the historically strong U.S. dollar and the decreasing
import prices, the drop in energy prices was initially dubbed
as “transitory” by the Fed. However, all of the
aforementioned factors persisted through 2015 and
formed a considerable force in the argument against Fed
tightening. A continuation of these trends in 2016 will likely
slow the pace of interest rate tightening and force the Fed
to revise the trajectory of their policy in the short- to
medium-term.
The instability of energy prices raises several concerns for
policy makers as they position monetary policy towards
normalization. First, the deflationary effect of the price
volatility continues to cause unease in the Fed’s decisionmaking process. Through 2015, the decline in oil prices
has been an extensive deflationary force, keeping headline
inflation well below desired levels. Perhaps a more
significant effect is the oil market’s influence on
policymakers. Fed officials began raising rates in
anticipation of a medium-term increase in inflation, which
is largely contingent upon the expectation of energy price
stability in the near-term. If oil prices stabilize, the Fed
expects inflation to quickly reach its target threshold for
further monetary tightening.
While deflationary concerns of further price suppression in
the energy market might be more pertinent to the current
outlook of policymakers, one can imagine that a sharp
rebound in oil prices (highly unlikely, yet possible) could be
disastrous to the domestic economy. A significant reversal
in price momentum could cause an unexpected
acceleration in inflation and potentially lead to an economic
downturn.
Secondly, the financial market volatility stemming from
plunging energy prices continues to worry Fed officials.
The freefall in oil prices dragged down equities across the
broad base of U.S. markets. Oil price movements recently
became a leading variable in the daily direction of stock
indexes. While the anticipated normalization of Fed policy
is expected to have an adverse effects on equities,
additional energy price instability could prove to be equally
detrimental to financial markets. Since the Fed’s
normalization agenda is expected to rock the boat, the time
might not be right if financial markets are already in choppy
water.
To be clear, the Fed doesn’t make policy decisions solely
based on the composition of the global energy market.
However, the negative effect of continued energy price
instability on the two pillars of Fed monetary policy
(employment and inflation) continues to cast a shadow
over the prospect of near-term tightening.
Near-Term Outlook
Prices in the energy market are expected to either stabilize
or continue descending through the first quarter of 2016.
Without major variations to the current landscape, the
imposing extent of the global oversupply practically
eliminates the possibility of a sharp sustained increase of
near-term prices.
Energy market suppliers are certainly engaged in
brinkmanship that continues to suppress prices. The
unrelenting production of Saudi-led OPEC intensifies price
instability as the organization attempts to flush out smaller
American producers that are unable to survive the lower
prices. Despite dissent from hurting economies like
Venezuela, OPEC members plan on sticking to their
production strategy, with several members even planning
to increase production in 2016. If current energy prices
remain, OPEC will likely cut production at some point in the
next several years. However, it might not be anytime soon
due to the expected resurgence of Iranian oil production
and the needed defense of market share.
Additional signs point toward further price suppression and
oversupply in the global market. Algeria, Africa’s largest
natural gas producer, intends to increase crude output by
5% over the coming year and offer energy-exploration
rights to foreign companies. Meanwhile, Russia signaled
that it has no intention of reducing output as it competes
with Saudi Arabia to be the top exporter of crude to China.
Russia remains highly dependent on its energy exports as
the nation relies on crude production for over 40% of its
budget.
As cut-throat suppliers drive prices lower in an attempt to
flush out competitors, their efforts are met with an
extensive decline in global demand. Pervasive
macroeconomic trends, such as slowed growth and global
deflationary pressures, will continue to threaten market
demand. The Chinese economic slowdown is a primary
concern. To further exacerbate the situation, reserve levels
of various oil importing nations swelled to new highs. For
example, U.S. commercial crude oil inventories are at
record levels with just under 500 million barrels amassed.
Strictly from a standpoint of supply and demand, any nearterm price increases would likely not be sustained due to
the magnitude of current inventories in oil consuming
nations. Therefore, price is expected to remain in the lower
2 end of the trading range over the near-term, with the
possibility of trending slightly lower.
Looking forward, we are still left with an array of questions.
If prices continue to trend lower, at what level will they
stabilize? When energy prices either stabilize or recover,
how swiftly will this stimulate U.S. inflation? Would a
reversal in price momentum have a negative effect on
consumer activity? How impactful will an energy price
stabilization be on financial markets? Will it continue to
influence the timing of the Fed’s normalization of interest
rates?
Most of these questions can only be satisfied in the course
of time. As radical energy price movements certainly
happened throughout history, the current price instability is
unique in that it coincides with an unprecedented global
economic landscape and a pivotal moment in U.S.
monetary policy.
References
Brown, S., M. Yucel, and J. Thompson. 2003. Business cycles:
The role of energy prices. Working Papers 03-04, Federal
Reserve Bank of Dallas.
About the Author
Ismail Ghodbane is responsible for
portfolio and securities management
and analysis, as well as reporting and
analytics, for fixed income portfolios. Ish
is also a member of the firm’s Investment
Committee. Prior to joining Detalus, Ish
was a Financial Analyst with Save-A-Lot
Food Stores, where he created and
maintained financial reporting and played key roles in
financial planning, forecasting, and budgeting processes.
He previously held positions as a Securities Operations
Specialist contracted at Wells Fargo Advisors and a Client
Services Reporting Analyst at NISA Investment Advisors,
L.L.C. He holds Series 7 and 66 licenses from FINRA.
Before his career as analyst and portfolio manager, Ish
participated in Georgetown University’s Arabic Language
Immersion Program and completed an Arabic and
Independent Research Study Project at Morocco’s School
for International Training. He also has a B.A. in Economics
from Denison University.
Hamilton, James D. 2005. “Oil and the Macroeconomy,” Palgrave
Dictionary of Economics.
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