Today’s collapse of commodity prices has the potential to cause a major financial crisis, as I first suggested back in June. In fact, this would now be my Base Case. But companies and investors have been lulled into complacency by unthinking ‘conventional wisdom’.
This simply ignored the obvious fact that record levels of commodity prices could only be sustained by ever-increasing amounts of stimulus. Now the Great Unwinding of these stimulus policies is underway, reality is appearing once more.
Oil markets are now reaching a very dangerous stage. Conventional wisdom in financial markets is that prices are just about to jump back to $100/bbl – amazingly, speculators keep adding to their upside bets, even as prices fall.
Yet the Executive Summary below from the International Energy Agency’s latest Monthly Report tells a completely different story (my emphasis in bold).
“As oil prices keep plunging, projections of short-term supply and demand balances stay the same – more or less – in the wake of OPEC’s decision last month to leave its production target unchanged. Since the last Report, futures benchmark prices fell by another $15/barrel, with Brent last trading near $65/barrel and WTI in the low $60s, 40% below their June highs. Several years of record high prices have induced the root cause of today’s rout: a surge in non-OPEC supply to its highest growth ever and a contraction in demand growth to five-year lows.
“Barring a disorderly production response, it may well take some time for supply and demand to respond to the price rout. Here’s why.
“When it comes to supply, lower oil prices are already slashing producers’ spending, but this is more likely to affect medium- and long-term output than short-term supplies. So long is the lead of oil projects that price swings can take time to work their way through to supply. Projects that have already been funded will for the most part go on. Non-OPEC supply growth for 2015 will not come close to its 2014 record, but prices have little to do with it – as things stand now. The short-term outlook for US light tight oil production remains unchanged at current prices as long as producers maintain access to financing. Only in Russia is oil’s plunge, along with sanctions and a collapsing currency, likely to trim 2015 production plans. A lower forecast of Russian supply is offset, however, by upward revisions to North American projections in view of the latest production data.
“As for demand, oil price drops are sometimes described as a “tax cut” and a boon for the economy, but this time round their stimulus effect may be modest. For producer countries, lower prices are a negative: the more dependent on oil revenues they are and the lower their financial reserves, the more adverse the impact on the economy and domestic demand. Russia, along with other oil-dependent but cash-constrained economies, will not only produce less but is likely to consume less next year.
“In oil-importing countries, price effects are asymmetrical: Demand lost to substitution or efficiency gains during prolonged periods of high prices will not come back in a selloff. Several governments are wisely taking advantage of the price drop to cut subsidies. Consumers thus might not see much of the decline. The dollar’s strength and oil sale taxes in some countries will also limit the feed-through from crude oil to retail product prices. In the OECD, a tepid economic recovery, weak wage growth and – last but not least – worrying deflationary pressures will further blunt the stimulus of lower prices.
“Based on current projections of still relatively weak demand growth and robust supply, global oil inventories would notionally build by close to 300 mb in 1H15 in the absence of disruption, shut-ins or cut in OPEC production. If half of this took place in the OECD, stocks there would approach 2 900 mb and possibly bump against storage capacity limits. The resulting downward price pressure would raise the risk of social instability or financial difficulties if producers found it difficult to pay back debt.
“Meanwhile OECD refining margins, which gained from lower feedstock costs in 4Q14, will likely come under downward pressures in 1Q15, as product stocks rebuild in the wake of surprisingly strong runs and as much as 1.4 mb/d of new refining capacity comes online.
“Continued price declines would for some countries and companies make an already difficult situation even worse. Today’s oil spending cuts will dent supply – just not right now.”
We can only imagine what will happen when markets finally realise that oil prices are going to stay at today’s level, or lower.