Oil prices could remain low for the next three years, according to analysts at Morgan Stanley. The investment firm likens the current market to the 1980s slump — the worst in history. A six year period, between 1980 and 1986, saw oil prices plummet by 50%.
Today’s prices are taking on a similar look.
The current decline picked up steam in the middle of last year. Oil prices fell from US$106 a barrel in July 2014 to US$49.42 by July 2015. That’s the lowest point since global prices bottomed out following the GFC in 2009.
What you’re probably interested in is whether Morgan Stanley is right.
So just what is the likelihood the price slump will extend through to 2018? Well, that depends on what you believe the underlying reasons are for current prices.
Morgan Stanley assessed four different market conditions to measure the probability for a price recovery.
Let’s now look at those in greater detail.
#1: Low prices should lead to demand for oil
In any market, a price fall should result in demand picking up. For a commodity as prized as oil is globally, we should see demand picking up drastically.
As it happens, global demand is up over the last year. According to Morgan Stanley, demand has risen despite China’s economic slump.
Since oil prices began sliding in June 2014, global demand has etched up by 1.6 million barrels per day.
So far, so good.
#2: Low prices should lead to cutbacks in spending
Another by-product of low prices in any given market is that companies tend to cut back on production. If there’s not enough revenue coming in to maintain expansion, then costs invariably come down.
The low price of oil should have forced producers to spend less on new drilling.
And that’s exactly what we’ve seen.
Since October 2014, drilling for new oil reserves fell by 42%, according to Morgan Stanley. Oil listed companies reduced total spending by $129 billion in the first six months of 2015. What’s more, the industry as a whole has shed 70,000 jobs during this period.
That means the first two conditions for a market rebound are present.
#3: Low prices should keep stock prices down
Since the slump, oil listed companies have seen their stocks fall in line with the market conditions. In the current low price environment, it’s only natural that stocks remain cheap. According to Morgan Stanley, the biggest oil producers are trading at 35-year lows.
Market leader Exxon Mobil [NYSE:XOM] has shed US$20 off its share price in the last year alone.
So far, three of the four conditions for a price recovery are in place.
But there’s one outlier that’s singlehandedly keeping prices low.
#4: Low prices should result in falling oil supplies
In any market that undergoes a price decline, it’s only natural for supply to fall as well. The theory of supply and demand explains this perfectly.
If prices go down, there’s no point in keeping supply high. Otherwise, prices will remain flat or slump further. That’s why all industries rein in supply once prices go down.
What’s strange about the oil industry at present is that we’re seeing the exact opposite to this.
Oil supply has actually gone up, despite the sharp fall in prices. Instead, global oil supplies should be going down.
It’s true that oil production in the US has fallen since June 2014. But OPEC, an intergovernmental organisation, actually increased its supply during the same period. That matters because OPEC represents 80% of the world’s proven oil reserves. At its head sits Saudi Arabia, the second largest oil producer in the world.
This factor is crucial in explaining why prices remain low. Without OPEC’s interference, prices would be much higher today than they are.
This means that only a reduction in market supply will set the stage for a price recovery.
Now, OPEC might point to an increase in global oil demand to explain their strategy. But that increase is down to prices being almost US$80 lower than this time last year.
Why is OPEC defying all basic economic laws?
The reasons why supply remains high amid low prices
There are three factors which may conspire to keep prices low for some time to come.
The first relates to OPEC’s desire to maintain, and expand, its global market share. The second is that it wants to do this by ruining the US shale oil industry.
Here’s the Telegraph’s take on OPEC’s crusade against competitors:
‘One starts to glimpse the extraordinary possibility that the US oil industry could be the last one standing in a long and bitter price war for global market share. [US shale producers could] emerge as an energy superpower with greater political staying-power than OPEC.
‘It is 10 months since the global crude market buckled, turning into a full-blown rout in November when Saudi Arabia abandoned its role as the oil world’s “Federal Reserve” and opted instead to drive out competitors’.
OPEC’s been successful in driving out high-cost producers, but America’s shale industry remains afloat. Because of this, it means that the price war could roll on for a while yet.
In terms of market share, OPEC is also keen to nullify the potential threat of Iranian oil. If the US-Iran nuclear deal goes through without a hitch, Iran will flood the market with oil, increasing global supply.
That would make it harder for OPEC to maintain its market share. It would also blunt any immediate price recovery.
Now, the final reason why supply remains high despite low prices is overtly political. For whatever reason, it’s also something that many economists dismiss out of hand.
OPEC, with Saudi Arabia at the helm, drove down prices to aggravate Russia’s economic situation. They did so at the behest of the US, which is seeking to oust Putin.
As the largest producer in the world, Russia’s economy relies heavily on oil revenues.
Considering the conflicts that have played out in eastern Europe, removing Putin has been of utmost important. The West has used economic instruments to try to achieve this, but it’s failed so far. Nonetheless, OPEC has done serious damage to Russia’s economy in the interim, and continues to do so.
Of course it helps that the attack on Russia coincides with OPEC’s assault on the US shale industry. But this only underlines how desperate OPEC is to kill off competitors.
Unfortunately for OPEC, both are still around. But this only suggests that the price war could continue for years.
So there you have it. Market share, US shale, and Putin. These are the reasons why oil prices have plummeted to the extent that they have.
Morgan Stanley thinks the pressures on oil stocks could force producers to cut back on supply. I’m not so convinced. Eliminating competitors, especially US shale producers, is of greater importance.
As long as OPEC’s market share strategy continues to drive the industry, don’t expect supplies to drop. All that means is that prices could remain low for some time yet.
Contributor, Markets and Money
PS: Oil producers have seen their share prices fall to 35-year lows. According to The Markets and Money’s Vern Gowdie, the broader stock market could follow this trend in the near future. He predicts the ASX200 is heading for a major correction in the near future.
Vern is the award-winning Founder of the Gowdie Family Wealth advisory service. He’s been ranked as one of Australia’s Top 50 financial planners. Not only does Vern see a major crash, but he thinks the ASX could lose as much as 90% of its $1.8 trillion market cap.
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