The three things driving the oil price
Energy markets are historically volatile, yet the price action of the past five years would put a roller-coaster to shame.
Oil prices hit an interim high of US$107 per barrel in June 2014 before plunging precipitously to US$46 per barrel in January 2015.
That’s a 57% crash in seven months.
This was due to a variety of factors.
US and global growth slowed materially from late 2014 to the end of 2015.
US growth was negative in the first quarter of 2014.
Growth bounced back in the second and third quarters before dropping below 2% in the fourth quarter of 2014 and finishing 2015 with two quarters below 1% on an annualised basis.
The Fed ended quantitative easing in November 2014 and began the ‘lift-off’ in interest rates with a rate hike in December 2015.
The pivot from ease to tightening in US monetary policy made the US dollar stronger and depressed the dollar prices of commodities such as gold and oil.
Single-digit oil prices were close…
Both the Organisation of the Petroleum Exporting Countries (OPEC) and major non-OPEC oil producers such as Russia were in disarray due to disagreements on output and quota goals, and widespread cheating on those quotas that were agreed upon.
Venezuela was trying to increase oil output to cope with its internal financial and political crisis (much worse today).
Iran began pumping more oil as the US eased sanctions after the November 2013 interim agreement and October 2015 final agreement between the US, Iran and five other nations on Iranian nuclear fuel enrichment.
Finally, US energy output expanded dramatically due to a combination of reduced restrictions on offshore drilling and greatly expanded fracking in North Dakota and Texas.
This combination of reduced growth, expanded output and a strong US dollar drove the oil price collapse from mid-2014 to late-2015.
The effects of this oil price collapse were no less dramatic than the collapse itself.
Russia’s hard currency reserve position fell 40%, from approximately US$500 billion to US$300 billion, as dollars from Russian oil exports dried up.
Russian companies had difficulty refinancing US dollar and euro-denominated debt as post-Crimea invasion financial sanctions imposed by the US began to bite.
The Central Bank of Russia offered little help to these companies (such as Gazprom and Rosneft) because its own hard currency position was under stress.
From 2015 to 2016, China’s hard currency reserve position also collapsed — from approximately US$4 trillion to US$3 trillion — as it spent US dollars to buy yuan in a vain effort to prop up the value of the yuan.
This was also a consequence of the strong US dollar policy initiated by the Fed.
As noted, the strong dollar translated into lower dollar prices for oil. In international finance, it’s all connected.
Oil prices continued their slide after 2015, hitting an interim low of US$27 per barrel in February 2016.
Some analysts were predicting oil prices in the teens, which brought back memories of oil at US$11.50 per barrel in July 1986 during the height of the Iran-Iraq War.
Oil price U-turn
Instead, oil prices did a U-turn and began a slow, steady rally.
Many of the causes were simply the opposite of those that caused the price decline.
The Fed only raised interest rates once in 2016 after promising to do so four times.
This stalled the dollar rally and gave commodity prices a stronger foundation.
OPEC discipline returned, and a powerful alliance between Saudi Arabia and Russia emerged to limit supply and boost oil prices (with some silent help from the US).
Most importantly, a coordinated global growth story emerged, particularly after the election of Donald Trump in 2016 and the passage of major tax cuts in late 2017.
In 2018, annual GDP growth in the US was the strongest in over 10 years.
As a result, oil rallied from US$27 per barrel in February 2016 to US$76 per barrel in October 2018 — a 180% gain in 31 months.
With lower production costs (partly due to bankrupt frackers in 2015 that allowed new money to buy assets for cents on the dollar), the profitability of the oil industry was higher than when oil was over $100 per barrel.
Oil corrected again in the fourth quarter of 2018, falling from the US$76 per barrel level to US$42.50 per barrel on 24 December, but this was due to excessive Fed tightening and a resulting strong US dollar. The oil price fall mirrored stocks, gold and other asset classes as the Fed came dangerously close to causing a recession.
In late December, a quick pivot by Jay Powell towards monetary ease restored the upward price momentum in stocks and oil.
Today, oil is trading around US$58 per barrel based on strong growth, monetary ease and a slightly weaker US dollar.
Iran, the Fed and the Strait of Hormuz
Given the oil price recovery beginning in late 2017 and the more recent bounce in oil prices, what are the prospects for oil and energy-related stocks in the months ahead?
Oil prices are set for a sustained rebound.
This does not mean that oil will go to US$100 per barrel or higher in the short run (although it could if the free passage of oil through the Strait of Hormuz is interdicted).
It does mean that the recent trend to higher oil prices will be sustained and that a major retreat is unlikely.
The Fed may or may not cut interest rates in upcoming FOMC meetings, but it is highly unlikely to raise them given current conditions of disinflation and slower growth.
The Fed will definitely end its quantitative tightening (QT) program of balance sheet reduction by September at the latest, and possibly as early as July.
Both moves are a form of easing relative to prior expectations and both will result in a weaker US dollar.
That translates into a higher US dollar price for oil.
For now, the Saudi Arabia-Russia-US condominium on oil prices is holding.
Venezuela and Iran are practically out of the market because of US economic sanctions. Resulting tight supply is another prop under oil prices.
Finally, the deteriorating geopolitical situation in the Persian Gulf requires little explanation.
Iran has attacked two tankers, shot down a US drone and engaged in other attacks using its proxy armies in Yemen, Gaza and Lebanon.
Iran seems willing to ‘wait out’ the Trump administration, based on private assurances from John Kerry and the European signatories to the 2015 Obama agreement with Iran.
These assurances may be misplaced, but they will stand in the way of new negotiations.
The result will be escalating tensions, including ‘invisible war’ involving financial, cyber and other non-kinetic attacks.
There is nothing in this scenario that will allow oil prices to fall far.
All the best,