Recent headlines have been dominated by oil prices. Having reached a peak of above $100 a barrel in June 2014, oil prices took the plunge and fell to less than $30 a barrel in February 2016. The severe rout had far-ranging consequences; a quarter million oil workers have lost their jobs and billions in share value have been erased from oil & gas companies. The downward trajectory has been accompanied by a marked increase in oil price volatility. According to Business Insider, oil prices have witnessed movements of more than 5% intra-day for 24 of the 26 trading days in February 2016 for the year-to-date. To give us a sense of the degree of price volatility, the table below illustrate the change in prices of oil in comparison to another commodity, aluminium.
|Sep 2015||46.29||1.25 %||1,589.60||2.68 %|
|Oct 2015||46.96||1.45 %||1,516.49||-4.60 %|
|Nov 2015||43.13||-8.16 %||1,467.89||-3.20 %|
|Dec 2015||36.56||-15.23 %||1,497.20||2.00 %|
|Jan 2016||29.92||-18.16 %||1,481.10||-1.08 %|
|Feb 2016||31.05||3.78 %||1,531.26||3.39 %|
What has caused such volatile but persistent price action to take place? In the short term, oil prices are driven by the prevailing market sentiment. Here the adage “buy on the rumour, sell on the news” resonates with the sharp swings in oil price as oil speculators and traders overreact to rumours about oil market developments and escalate a trend in the established direction.
Over a longer horizon, depressed oil prices can be attributed to the imbalance between supply and demand. Rather than a simple relationship of cause and effect, changes in either supply or demand trigger multiple feedback loops that act on and influence each other. On the demand side, the emerging markets boom in the early 2000s has given away to sluggish growth after the 2008 financial crisis. This has resulted in a tanking market of rapid declines in commodity prices including oil. Additionally, China’s pivot away from a manufacturing economy had lowered their need for oil. Secular drivers of growth such as investing in infrastructure, consumer spending and rural-to-urban migration are low-hanging fruit that have been plucked. This leaves China to deal with the nascent challenges of an aging workforce, diminishing returns from urbanization and a weaker global market for exports.
On the supply side, a mix of technological and political factors have shored up production and impaired quantity adjustments from accommodating the mismatch resulting in a magnified price response. The flexibility of US fracking to scale and adapt production levels has bolstered its resilience in an environment of weak prices. Advancements in fuel efficiency have also resulted in poor demand growth as vehicles implement lighter frames and efficient combustion processes. Moreover, substitutes for oil such as renewable energy have gained traction amidst a rallying green movement.
Political forces have contributed significantly to the sustained downward trend. OPEC’s decision to hold production steady and deviate from its previous action of limiting output has hindered the price recovery process. Whether OPEC’s actions are a political conspiracy to squeeze out US production is uncertain, but OPEC’s actions have certainly distorted market expectations and reinforced the bleak outlook. Russia’s dependence on oil and need for income has also resulted in increased production in light of the sanctions imposed by Western Nations. At the same time, the lifting of sanctions for Iran can lead to more supply coming online and weigh on a price rebound.
Besides physical supply and demand drivers, financial developments have played steadily into influencing the price patterns of oil. Interest rate hikes by the Fed might cause the USD to strengthen, which could precipitate a fall in price of US-produced oil given that it is more expensive on forex terms. This is significant as advances in fracking technology boosted the US to be the world’s largest oil producer in 2014, producing an average of 11 million barrels of oil a day.
However, while the price of ‘black gold’ will be a moving target that lies off equilibrium, its value as a key driving force in powering humanity forward is unlikely to change.