How Low Can Oil Prices Go?

Most investors have the good sense to ignore the daily barrage of market statistics. But the recent sharp drop in oil prices seems to have caught everyone’s attention. Over the last six months, oil prices have fallen 50% to levels not seen since 2009.

The causes of the decline are pretty straightforward. Oil is a commodity and like any commodity its price is dictated by supply and demand. On the demand-side, weak economic growth in large energy importing countries such as China, Germany and France is putting downward pressure on prices. On the supply side, there have been production increases in energy exporting countries (Russia, Libya) and the U.S. is also adding to the problem. Consider that thanks to new fracking technology, the U.S. alone has added 4 million new barrels of crude oil per day to the global market since 2008.  

Price volatility is not uncommon in the oil patch. Back in 1973, oil prices soared from about $3 a barrel to over $35 a barrel in 1980. Today’s price decline will produce both winners and losers. Companies in the business of extracting oil are feeling the most pain, particularly those with high costs and heavy debt burdens. Large, integrated energy firms such as Exxon Mobil and Shell are not happy with falling commodity prices but they have refining and marketing businesses and lots of cash to fall back on. Energy exporting countries, particularly those with weak credit ratings and a high dependence on oil will be vulnerable (see chart above).

Companies where oil represents a major cost, for example truckers and airlines, are clearly benefiting from lower prices as are major importing countries such as South Korea, Japan and India. Consumers, now facing lower gasoline and heating bills, are also major beneficiaries. According to the EIA, US drivers will spend about $550 less on gasoline this year than last.

Unfortunately understanding the secondary or “knock-on” effects of lower oil prices is not easy. Low oil prices have the potential to upend politics in energy dependent countries such as Russia, Venezuela and Iran. Selling by sovereign wealth and hedge funds that have bet heavily on higher oil prices could disrupt financial markets while the case for alternative energy is more difficult in a world where competing fuel sources are now 30% lower than before.

Most economists today expect oil prices to rebound back to the $70 level by the end of the year as lower oil prices spur consumption. But I would not place too much confidence on the exact timing of any rebound. Many energy firms will continue to pump as long as oil prices remain above what can be relatively low marginal costs of production. And OPEC has recently signaled that maintaining market share at the expense of profits is their priority.

The recent oil price decline illustrates, once again, how difficult it is to predict commodity prices. Consider that at the start of last year, the consensus average 2014 oil price forecast by economists in a poll by Bloomberg stood at $105 a barrel. A wide range of factors caused the current price decline and a change in any one of them, from economic growth in China to an outbreak of conflict in Libya, could give rise to further price changes. As always, supply and demand will eventually come into balance. How and when this occurs is the $64,000 question.