In October, the price of West Texas Intermediate (WTI) crude was US$70 a barrel (bbl) and we wrote a positive commentary about energy markets. The price subsequently climbed a few dollars higher but has since fallen to US$56/bbl (at the time of writing this commentary on November 13, 2018).
WTI Cushing Crude Oil Spot Price - November 13, 2017 to November 13, 2018
Source: Bloomberg Finance L.P.
So, what happened?
The price of oil is based on supply and demand fundamentals combined with – at times – a not insignificant dose of political interference. As discussed in our prior write-up, supply had been relatively limited due to a lack of investment globally. This was supportive of stronger pricing. Demand has been rising steadily in recent years, also supportive of stronger pricing. And the market was concerned about U.S. sanctions against Iran potentially causing a supply reduction of 0.5-1.0 million barrels per day (b/d), which would have further tightened the market.
Here is where the political interference likely kicks in. U.S. President Donald Trump had been tweeting about oil prices being too high. This is something that was a big concern to him leading into the midterm elections. Saudi Arabia is a close ally of the U.S. in the Middle East, particularly with respect to containing Iran. So, with the expectation of Iranian barrels coming off the market, Saudi Arabia ramped up production from March 2018 to October 2018 by approximately 800,000 b/d.
Meanwhile, Russia – long engaged in a battle with Saudi Arabia for global oil supremacy – also increased production over the same timeframe by approximately 300,000 b/d. A few other OPEC (Organization of Petroleum Exporting Countries) producers increased capacity where they could, with the total combined result being an approximate 1.5 million b/d increase to global oil production.
On the demand side, in the past few months the global economy has been showing some signs of weaker growth. While real-time demand data is virtually impossible to come by, it is reasonable to assume that global oil demand has weakened somewhat with a slowing global economy.
Put these things together and you have an oil market that likely went from a marginally under-supplied situation to a marginally over-supplied situation. The key word here is “marginally”. With commodities, price moves tend to be exaggerated (both on the upside and the downside) compared with the underlying supply-demand fundamentals, since price is the only market-balancing mechanism in the short term. So, a slightly under-supplied market can result in large upward price movements, while a slightly over-supplied market can result in large downward price movements.
What we are now experiencing is the downward side of that dynamic.
One significant development that the oil market, in its newfound bearishness, seems willing to overlook: the world is rapidly running out of spare oil production capacity. Recent estimates suggest OPEC has less than 2 million b/d of remaining spare capacity or less than 2% of global demand. This is near all-time, record lows. If there is any further hiccup to the global oil supply chain, it is unclear which producer would have the ability to increase near-term production to make up the shortfall.
In a nutshell, Saudi Arabia and a few other producers used their (limited) spare oil capacity to supply the market in the short-term for both fundamental and geo-political reasons. They seem to have gone too far, and the market is punishing them for it with a rapid decline in the oil price. Having just emerged from a brutal four-year oil price downturn that devastated the finances of OPEC-member countries, they will not wait long to respond in the other direction. We expect to see OPEC and its allies act swiftly and decisively to cut oil production and bring balance back into the market. OPEC’s recent actions have caused a temporary delay, but not a long-term change to our outlook: We maintain our positive stance on oil prices over the next 12-24 months.
Bob Lyon is a portfolio manager on the Signature Global Resource Fund, Signature Global Resource Corporate Class, Signature Global Energy Corporate Class, Signature Income & Growth Fund, Signature Income & Growth Corporate Class, Signature Canadian Balanced Fund and Signature Gold Corporate Class.
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