What is the Story on Oil?

What is the Story on Oil?

As all of us enjoy the benefits of lower gas prices, many people are also transfixed with the continued drop in oil prices and wonder what is going on with oil. There has been much discussion about the reason for the drop in oil prices with many explanations provided.  The fundamental reason for the drop in oil prices is simple: there is an excess supply of oil compared to the demand for oil. Demand has slowed due to the economic slowdown occurring throughout the world, especially in China, Europe and Japan. Although the U.S. economy appears very healthy compared to these other economies, the reality is that the U.S. is a fairly mature market for oil demand. The U.S. has actually been reducing its overall demand for oil over the last decade. Excess supply exists because the U.S. production of crude oil has grown from 4.7 million barrels a day in 2008 to 9.0 million barrels a day today. Normally OPEC would reduce supply to offset increased production of non-OPEC countries in order to keep oil prices stable. This time OPEC chose to not reduce supply, led primarily by Saudi Arabia.

Why would Saudi Arabia choose to keep production levels unchanged and create an excess supply of oil? Once again, there are numerous theories being tossed around but the most credible appear to be one based on business fundamentals and the other based on geopolitical fundamentals. The business fundamental explanation is that Saudia Arabia is defending market share. As the U.S. has ramped up oil production, this has created competition for Saudi Arabia. As a “business” that has low operating costs and break even points, Saudi Arabia appears to be using its clout to try to shut down the marginal shale oil producers in the U.S. This is a classic case of a big business cutting prices to weed out the competition. Saudi Arabia is estimated to have over $750 billion in reserves to help offset the lower revenue.

The other explanation is a geopolitical explanation. In essence, Saudi Arabia appears to have declared an economic war on Iran. At risk of oversimplifying a complex situation, Saudi Arabia has a long history of conflict with Iran which is religiously/culturally based. Saudi Arabia is comprised primarily of Sunni Muslims while Iran is primarily Shiite Muslims. The economic war appears to be centered around Syria with Saudi Arabia supporting the rebels while Iran and Russia have been supporting the Syrian regime. Since Saudi Arabia has no desire to take on Iran militarily, their best weapon is an economic weapon: oil. Here is some perspective that helps lend credence to an economic war.

1) According to an analysis by Reuters, from a pure business perspective, the breaken cost for crude production is not much different between Saudi Arabia and Iran. Saudi Arabia is just below $30 a barrell while Iran is just above $30 a barrel. The breakeven cost for Russia is over $80 a barrel.

2) More importantly, the breakeven cost for Iran to continue funding their social programs is just over $135 a barrel while Saudi Arabia is just over $90 a barrel. The difference is that Saudi Arabia has far deeper monetary reserves to continue to fund their social programs.

Lower oil prices may serve two geopolitical purposes for Saudi Arabia.

1) Create economic distress for Iran and Russia which causes them to cut back their military funding to Syria.

2) Create social unrest in Iran that might ultimately bring about an overthrow of the current regime.

Many of you may think that this is all very interesting but how does it impact the U.S.?

The answer is that lower energy prices both help and hurt the U.S. economy. Here are some facts provided by one of the independent research firms that we use (Strategas).

1) Jobs: Since January of 2008, energy has accounted for 15% of U.S. jobs growth even though the energy sector only comprises 1% of total employment in the U.S. Clearly, jobs growth may be negatively impacted if the energy sector reduces its pace of jobs growth unless other sectors of the economy pick up the slack.

2) Inflation: Energy makes up 9% of CPI. All else being equal, the 39% drop in oil prices will lower CPI by approximately 1%. That is good news for consumers and businesses that consume oil but bad news for businesses that produce oil.

3) Spending: If oil prices remain at their current levels through 2015, that represents a $192 billion stealth tax cut. The question is whether that energy savings will translate to spending or if it will be used to rebuild savings or pay down debt.

Saudi Arabia is a close knit culture and the true reason behind the Saudi strategy may never be known. At this point, the two explanations provided above appear to be the most credible. Needless to say, the massive decline in oil has created uncertainty over the ultimate economic impact from this price action.

From an investment markets perspective, whenever uncertainty raises it ugly head, volatility rises in the investment markets. This can be seen from the decline in risky assets and the rise in “safe haven” assets. The ripple effects from oil highlight the age old argument for diversification. Those who have been concentrating their investments in the riskier assets because of the higher growth rate over the past 5 years may discover that life becomes a lot more volatile if external (especially geopolitical) events take on a bigger role in 2015.

About The Author

Steve Scranton is the Chief Investment Officer and Economist for Washington Trust Bank and is a CFA charter holder with over 30 years of investment experience with equities, tax-exempt and taxable fixed income securities. Steve actively participates on committees within the bank to help design strategies and policies related to client and bank owned investments. Steve also serves as the economist for the Bank and has been a featured speaker for both client and professional organization events throughout the Northwest.