Oil had held above $100 based on several factors. Instability in many oil producing regions led to concern over imminent supply shocks (Libya, Iraq, Nigeria, Venezuela, Russia) while successive rounds of quantitative easing led to a rise in the purely financial trading of oil (a rise in liquidity will typically boost asset prices).
These factors have divorced the oil price from the factors that should theoretically guide it, but in the last few years, at a price higher than fundamentals merited.
Performance of oil since Jan 2014
Source: FE Analytics
In fact, for several years, demand and supply have been broadly in balance according to the International Energy Agency. They calculated that in Q3 of 2014 there was about 0.7 per cent excess supply though oversupply is forecast to increase in 2015.
Through this period, the cost of the final barrel of oil extracted to satisfy demand was probably about $85 (hard to assess with precision, but a reasonable guess given what we know of the unconventional and expensive extraction methods such as shale oil and tar sands in Canada).
The trouble has been that the price has stayed high for so long that some investors got carried away. They posited that since demand broadly equalled supply and oil traded above $100 in that environment, then that was the new stable price. They began to invest on that basis and new supply was slated to come on.
Unfortunately, no market can defy fundamentals indefinitely. It is hard to identify the catalyst to the fall we see now. A combination of a decrease in demand growth from China, extra supply stimulated by the high price began to be noticed, but the fall accelerated when it became clear that OPEC could no longer control the price. One suspects that its statement to the effect that it will no longer defend prices but rather its own market share, belies the fact that it lost control of pricing a long time ago.
So what of the present and the future? Were oil to continue to trade below $50, significant supply would become unprofitable and end up being driven out of the market, and much planned future production would become unviable.
This would put the market in serious deficit, surpluses would disappear and fundamental buyers would bid the price up until enough supply became viable thus returning the market to a balance. That is the cold hard economic truth of it.
In fact, the current low price is arguably storing up the seeds of the next bubble and the longer it persists, the frothier that bubble. Oil projects are by nature long term and expensive. If we shelf supply now and do not prepare more, then we could see a round of genuine shortages as we proceed through the energy cycle. That could make $100 oil look cheap.
Consumers and policy makers should enjoy this oil price fall while they can. It will not persist for a significant period, though it could easily fall further since supply does not shut off overnight. We are feeling the benefit of its effect on our cost of living at the moment, but if the price stays where it is, then it will have washed out the inflation numbers in a year, and if I am right, then it will be beginning to contribute to rising inflation again.
Andrew Herberts, Head of Private Investment Management (UK), Thomas Miller Investment
