The last few days have witnessed a further sharp fall in oil prices after the rally in late 2016 caused by the agreement between Russia and OPEC to cut oil output.
It is generally acknowledged that the terms of the agreement have been fulfilled, and that the two biggest producers – Saudi Arabia and Russia – have indeed cut production as they promised. Nonetheless oil prices are now falling again.
Partly this may be due to market expectations that the Federal Reserve Board will announce at its next meeting a further increase in interest rates.
As I have repeatedly explained, because oil is priced in dollars and because of the tendency of traders to buy oil as a hedge against falls in the value of the dollar, the dollar price of oil is very sensitive to movements in US interest rates, with rises in interest rates typically causing falls in oil’s dollar price as they cause the value of the dollar to increase. It was the prospect of a rise in US interest rates following the end of the US Federal Reserve Board’s quantitative easing programme, which was the main cause for the crash in the oil price in mid 2014.
The likely coming increase in US interest rates is however probably only a marginal factor in the latest price fall. By now – more than two and a half years since the start of the crash – the market has priced in the effect of rising US interest rates into the oil price.
There has been some talk that some of the latest fall in oil prices is the result of speculative long positions in the market. However there seems little doubt that the major cause of the fall is the build up in US inventories caused by a surge in output of oil from US shales, which has had the effect of worsening the supply glut.
If so then this reinforces my longstanding view that the attempt to end the supply glut artificially by cutting production in Russia and Saudi Arabia was a mistake.
The supply glut was a natural response by producers to the fall in oil prices, as producers reacted (as they always do during a price fall) by stepping up their production in order to maintain their cash flows. The supply glut was however never very large, with all the indications pointing to a rebalancing of the market in the second half of 2016, with a rebound in oil prices towards the end of the year.
In the event it looks as if the production cut and the previous talk of a production freeze caused the oil price to rise prematurely and too far, delaying the full rebalancing of the oil market, with the major beneficiaries being the US shale oil producers.
The initial impetus for the production cut appears to have come from neither Saudi Arabia nor Russia – both of whom are known to have been skeptical about the idea – but from Venezuela, which has been thrown into crisis by the oil price fall. If oil prices now fall again it will provide further proof that in a situation where the US – the world’s third big oil producer alongside Saudi Arabia and Russia – refuses to cut production under any circumstances, artificial cuts by other producers to prop up weaker producers in the end simply benefit the shale producers in the US.
The Saudis are now hinting that they may not be prepared to extend the production cut further when it expires at the end of May, in which case the oil price may fall further.
Should that happen I don’t personally expect oil prices to fall unduly. If they fall below $40 a barrel I doubt they will do so for very long. The reason is that I personally doubt that the effect of the production cut on prices was actually very great, if only because it was actually quite small and its duration was very short. Moreover rising economic growth in US, Europe and Asia should eventually provide support for prices.
The events of the first few weeks of 2016 – when oil prices collapsed to historic lows – suggests that the absolute lowest possible floor for oil prices in current conditions is around $30 a barrel. I personally doubt that this time, given rising economic growth, the oil price will fall so far. However predictions of where oil prices will go over any period regularly turn out wrong and no-one – certainly not me – can ever say with any confidence where oil prices will be at any specific point in time.
Should oil prices continue to fall, then because of the floating rouble the effect on the Russian budget and on Russian inflation will be limited, just as it was in 2016. Indeed because of the fall in the rouble the Russian economy would become more competitive, which might conceivably even cause economic growth in Russia to be higher.
In the not so long term it is likely oil prices will anyway begin a sustained rise as higher economic growth and reduced investment in new production which has taken place since 2014 start to have an effect. Suggestions that the oil price might increase to $70 a barrel do not seem excessive, though it will be the state of the global economy and interest rate policy in the US which will in the end decide the price.