Oil price falls on unexpected supply and demand dynamics
What’s going on here?
Crude oil prices are down more than 30% from their October highs. The sharp pullback is likely attributable in large measure to three factors that have materially softened short-term supply and demand prospects for the oil market.
- Rising oil supplies from the United States, OPEC and Russia
- Temporary relief for countries reliant on Iranian Oil exports
- And forecasts for weaker-than-expected demand growth
These supply and demand factors pushed the price of US West Texas Intermediate (WTI) crude oil down from more than $74 per barrel; however, the market may have gone too far during its record breaking 12-day sell off. We expect oil prices to stabilize this year and remain firm into next year.
Supply and demand in detail
The US has increased its oil production as higher prices encouraged drillers to expand output. Today, the US produces almost 3 million more barrels of oil per day than it produced two years ago. Meanwhile, OPEC and Russia continue to supply crude oil at an increasing rate (figure 1) together producing an additional estimated 2 million barrels per day versus May 2018. Last month, investors received early warning signs that supply could be overshooting based on, above average, crude oil builds in the US (figure 2).
Total Oil Production
Source: Bloomberg, Department of Energy, OPEC, NYLI SAS. As of 11/14/18.
Total Change in U.S. Inventories
Source: Bloomberg, Department of Energy, NYLI SAS. As of 11/14/18.
Markets expected Iranian sanctions to drastically limit supply. The United States, however, granted exemptions to eight countries which allows them to temporarily continue to buy Iranian oil. These countries compose Iran’s top importers of oil. As such, the temporary waivers are a large change to expected oil balances from only a short time prior.
Market concerns about energy demand are also weighing on oil pricing. For example, emerging markets are particularly price sensitive when it comes to their energy use. So, when prices rise or economic growth tapers, additional oil demand may not be as apparent. OPEC now forecasts global oil demand to grow by 1.29 million barrels per day in 2019 – almost 200k less than estimates in July.
Why does it matter?
When oil prices drop precipitously investors get a bit touchy. That’s because oil prices historically move in tandem with global economic growth and corporate earnings. In general, the annual change in the price of oil positively correlates with the annual change in the S&P 500 index EPS 6-months ahead. During more extreme pull backs in WTI Crude oil, the effect on corporate earnings and equity market pricing was more significant.
Oil vs. EPS
Source: Bloomberg, New York Mercantile Exchange, Standard & Poors, NYLI SAS. As of 11/14/18.
A mixed bag
A lower oil price offers a mixed bag for investors. On one hand, cheaper oil can reduce profits in the oil-dominated energy sector, as well as countries reliant on exporting oil. On the other, lower oil prices reduce costs for industries that use oil as an input, such as travel, transportation, and manufacturing, which could in turn reduce pressure to raise prices. This comes as good news for the economy and consumers who now have more money to spend. Since consumer spending is the largest component of GDP for many countries, the good news could outweigh the bad news of lower oil prices. However, sustained low oil prices could signal that markets are worried about a broader economic slowdown, which could weigh on investor sentiment.
We expect prices to stabilize and perhaps strengthen into 2019. To begin, we do not expect 2019 to be a year of substantial oil supply surplus. Producers are unlikely to tolerate substantially lower prices and could reduce production if necessary. In addition, the current waivers for countries receiving Iranian oil are temporary. They do not materially soften the US intent to squeeze Iranian crude out of the market. Finally, global economic growth – while it has likely peaked – remains strong. Demand for oil is likely to remain robust enough to support prices in the coming year.
Annual Oil Demand by Region
Source: OPEC World Oil Outlook, NYLI SAS. As of 11/14/18.
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The Standard & Poor’s 500 Index (S&P 500) is an index of 505 stocks issued by 500 large companies with market capitalizations of at least $6.1 billion. It is seen as a leading indicator of U.S. equities and a reflection of the performance of the large-cap universe.
The S&P 500 Energy Index comprises those companies included in the S&P 500 that are classified as energy related.
West Texas Intermediate (WTI) crude oil is the underlying commodity of the New York Mercantile Exchange’s oil futures contracts.
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