Weekly investment: We’re all oil experts now, aren’t we?

If the market generates lower oil prices, the effect will be all the more dramatic when prices eventually do recover. (Shutterstock)

We are now all experts in the oil market, aren’t we? If the market generates lower and lower prices for crude and these become embedded in investors’ psyche, the effect will be all the more dramatic when prices eventually do recover. We all know there is oversupply, and that it is substantial, but low prices do encourage demand, and we are now seeing meaningful cuts in capital spending by energy companies.

The IEA reckons such spending is running about 20% lower this year, compared to 2014, and has noted that 2014 was the 4th year in a row that the number of new oil discoveries fell. Yes, shale production has helped U.S. oil production increase by almost 70% since 2009, yet this amounts to just 5% of total global production, (according to a report published by oilprice.com earlier this year), and current prices have made more and more of this production uneconomic.

The Saudi Arabian ‘go for market share’ logic may yet at least partially win-out, albeit with much pain for oil producers in the interim. Lastly, there is always the possibility of a major event increasing what is probably a relatively low ‘geopolitical premium’ - and there are large short positions in the market. Also, note that Iran has been accused of recently conducting a ballistic missile test, which would violate the agreed terms of the P5+1 nuclear agreement. The U.S. State Department is reportedly investigating.

WTI is currently quoted at $35.40, with Brent a few dollars higher than this, and we think this is probably the final ‘blow-off’ stage on the downside, following the disastrous OPEC meeting just over a week ago. Our short-term expectation of about $35 on WTI (the bottom of our envisaged range) has effectively been hit, also driven by comments in the IEA’s monthly report to the effect that OPEC production has increased to 31.7 million barrels/day.

The latest down-leg in oil prices will, if sustained, reduce inflation/add to deflation, and ensure a greater uptick in inflation when oil prices finally do recover. Meanwhile, the Bloomberg Commodity Index is at a 16-year low; this index currently has a 22.3% weight in energy, and 15.0% in crude oil specifically. While it is true that falls in commodity prices signal economic weakness, they can also reflect extreme bearish sentiment and the (often large) related short positions.

Short-squeezes can and will occur, and when markets finally do turn they can cause prices to move spectacularly to the upside.

As in the energy sector, mining companies have reduced their capital expenditure and made job cuts, all of which sow the seeds of commodity price recovery, and often in advance of demand recovery.

Also consider that if the dollar even partially reverses, because many commodities are quoted in dollars their prices in other currencies will be commensurately lower - hence boosting demand, maybe not hugely, but enough to make a difference to prices.

Last Update: Wednesday, 20 May 2020 KSA 09:47 - GMT 06:47