Oil Prices: What Next?

sad day

By G. Allen Brooks 2016-04-25 20:50:58

Falling oil prices and China’s economic slowdown have investors spooked. Will 2016 be as bad as it looks?

Since OPEC gained control of oil prices in the early 1970s, global turmoil has always been reflected by a jump in oil prices. This year started with potentially the most significant geopolitical tension in recent times, but instead of oil futures climbing, they fell.

WTI, the benchmark of U.S. oil, has traded below $30 a barrel, a level not seen in a dozen years. In just over 13 months, oil prices have been slashed by more than half. Eighteen months ago, WTI was over $107 a barrel and has now fallen by over 70 percent, a decline usually associated with an economic collapse rather than a typical oil industry downturn. 

Everyone wants to know: Where is the “fear premium” associated with oil prices when consumers believe geopolitical, financial or economic mayhem might cut off global oil supplies? Has the oil market reached a tipping point where demand concerns now outweigh supply matters? Should we worry about peak oil demand or are we merely being swamped with too much oil?

Mideast Turmoil

Major geopolitical events kicking off 2016 included North Korea exploding a hydrogen bomb and Saudi Arabia executing 47 terrorists, including three Sunni members of al Qaeda, three Shiite jihadists and a leading Shiite dissident cleric, Sheik Nimr al-Nimr. These jihadists had been convicted of attacks on Western compounds, government buildings and diplomatic missions in 2003-2006, or shootings and bomb attacks killing police during the Arab Spring protests of 2011-2013. The execution of Sheik al-Nimr was probably more for his firebrand rhetoric against the Saudi royal family than his involvement in the deaths of policemen.

The executions were designed to send a message, both at home and across the Middle East, and principally to Saudi Arabia’s leading foe in the region, Iran. Sheik al-Nimr was the acknowledged leader of the younger, more militant Shiites concentrated in Saudi Arabia’s Eastern Province, home of much of the country’s oil production. His fiery speeches were a problem because they not only incited domestic violence among local Shiites but also radicalized Sunnis determined to depose the current king. 

While Shiites represent less than 15 percent of Saudi Arabia’s population, their concentration in the heart of the nation’s oil-producing region has always concerned the royal family. Shiite protests during the Arab Spring in 2011 and since prompted an aggressive response from the government, which has grown more hardline under the leadership of King Salman. Since his ascension to the throne in January 2015, executions have increased.

At least 157 were executed last year, a significant increase from 90 in 2014. The latest executions came despite threats of retaliation by al Qaeda. The simultaneous execution of 47 people – 45 Saudis, one Egyptian and a man from Chad – was the largest mass execution for security offenses in Saudi Arabia since the 1980 killing of 63 jihadist rebels who had seized Mecca’s Grand Mosque in 1979. 

The reaction to the executions was outrage from Shiites both in Saudi Arabia and throughout the Middle East, and especially in Shiite-dominated Iran. Iranians had hailed Sheik al-Nimr as a champion of the marginalized Shiite minority in the Kingdom. The outrage in Tehran caused mobs to attack the Saudi Arabian embassy, setting it on fire. In response, Saudi Arabia severed diplomatic relations with Iran, ordered the closing of the Iranian embassy in Riyadh, and expelled all of Iran’s diplomats. 

Oil traders initially thought this escalation of tensions between the Middle East’s leading Sunni and Shiite governments could disrupt oil flows. After further consideration, they saw that the exchange was more a war of words than of actions. If the ongoing proxy wars between these two Muslim factions in Syria and Yemen had yet to disrupt oil flows, why would this war of words? Traders drove oil prices lower on continued oversupply concerns.

The China Factor

Traders then worried about negative economic and financial news from China. The latest China Manufacturing Purchasing Managers’ Index report for December fell to 48.2 from 48.6. Not only was the decline of concern, but the index remained below 50, signaling a contracting Chinese economy. China also suffered from the largest monthly decline ever in its foreign currency reserves, and the government of the northern province of Hebei, which accounts for a quarter of China’s iron and steel production, slashed output due to bulging inventories and weak demand. 

These statistics point to China’s challenge in trying to shift from a manufacturing and export driven economy to a consumer-based one. As pointed out by David Levy of the Jerome Levy Forecasting Center, the ability of China to rebalance its economy will prove much more difficult than many people anticipate. Manufacturing capacity utilization in China is probably about 50 percent or less, yet 46 percent of the country’s GDP comes from investment. 

China’s challenge comes from the magnitude of the shift required. At its peak in 1990, Japan’s government and private investment totaled 33 percent of GDP. Likewise, in the U.S. during its greatest investment boom following the end of World War II, when we built schools, infrastructure and our interstate highway system, the highest the ratio of total investment to GDP got was about 25 percent. 

Further challenging the ability of China to shift its economy is the country’s banking system where 80 percent of loans are directed to government-sponsored entities. Many of them are being kept alive by these loans, leaving little capital available for new and healthy enterprises. As China struggles to adjust, the government must foster consumer demand while trying to minimize the fallout from lower exports. One way to facilitate the shift is by manipulating the value of its currency. 

The yuan is pegged to the value of the U.S. dollar, although Chinese finance officials have been allowing it to slowly decline. That depreciation makes it more expensive for Chinese citizens to buy foreign goods and to travel internationally. By inflating the cost of imported goods that the Chinese want, the government hopes they will begin buying domestic goods instead.

The problem, however, is that the slow depreciation rate last year suddenly became a rout in the first week of 2016 as Chinese citizens began shipping more of their wealth abroad to protect its value. In the first ten days of 2016, the yuan depreciated by 10 percent, a decline that spooked investors who reacted by hammering Chinese stock prices. 

Bright Spots?

While China’s economic outlook remains questionable, the two current global bright spots are the U.S. and Europe, but each for different reasons. On the continent, the E.U. central bank’s “easy money” policy is helping boost economic activity. European economies are further aided by a strong U.S. dollar that enhances the attractiveness of European exports to U.S. consumers. 

On this side of the Atlantic, the recovering U.S. economy seems to be gaining strength, led by strong automobile sales and a rebounding housing market. Weakness in oil patch state economies has been offset somewhat by the economic boost from low oil prices for the rest of the nation. The offset could have been stronger had consumers not elected to save large portions of their energy windfall in anticipation of a snapback in oil prices. 

The challenge of a bifurcated global economy is that investors read China’s problems negatively, sending Chinese stock markets down sharply. On several days stock prices fell by more than seven percent, which triggered market circuit breakers that shut down further trading.  The trading stops generated more fear among investors about China’s economic health. The knock-on effect saw the Dow Jones Industrial Average suffer its worst performance for the first week of a year since 1792! 

Stock market volatility is exploding around the world, causing increased concern globally among government and financial officials. Is this the start of a global recession? Will a Third World War emerge from the regional struggles among Muslim nations in the Middle East? Will a further decline in commodity prices – especially oil and gas – create an explosion in energy company bankruptcies? Since low oil prices have failed to provide the economic lift expected, observers are questioning whether we may experience other unintended consequences from the end of the commodity super-cycle.

Many questions, few answers.

Reign of Fear

At the moment, fear is gaining the upper hand. Will the worst opening week for the stock market become the worst opening month and possibly the worst opening quarter and maybe even the worst year in modern times? The inability to foresee the future doesn’t negate the possibility that once this storm passes we will move into tranquil seas, and fear will turn to optimism. Writing off 2016 now would be a mistake. 

However, questioning one’s strategy is never a mistake. Spending time contemplating unthinkable scenarios (oil in the $30s a barrel!) is not a waste of time because the exercise may illuminate beneficial adjustments to one’s strategic plan. 2016 may yet become one of the most consequential years for the energy industry in decades. Exactly how remains unknown. – MarEx

The opinions expressed herein are the author's and not necessarily those of The Maritime Executive.