Oil prices sank to six-year lows in August as a supply overhang grew and concern deepened over the health of the global economy, especially in China. Oil prices have since stabilized around $50 per barrel but a production gap has emerged between OPEC oil producers and the rest of the world’s oil producers, including the United States. Why would some oil producers continue pumping oil when global demand is low and oil prices have fallen into unprofitable levels? There seems to be a powerful undercurrent in this volatile time in global energy history.
As you can see from the chart below, world GDP has declined steadily since 2010 and continues to do so. A slowdown in global economic output has decreased global demand for commodities, including oil. The global commodities complex has seen dramatic price declines and the world commodities index is currently at a 16-year low.
According to data taken from the International Energy Agency (IEA), demand for oil has been declining since 2012. Usually, when demand for oil falls OPEC and other oil producers close down rigs and stop producing oil in order to get oil prices to stabilize and remain above profitable levels. However, this has not been the case; oil prices have plummeted from over $100 a barrel at the end of 2013 to their current price of $48 per barrel.
The demand for oil has declined over the past four years but the global supply for oil has not decreased quickly enough to stabilize prices. According to Baker Hughes International Rig Count Data, the overall rig count in the world has declined by almost 50%, but why have prices not adjusted upward?
If you look closer into the Baker Hughes International Data you will notice that the global declines in supply have not been consistent throughout the world. The United States and Canada’s rigs have declined by 50%, Latin America and Africa by about 30%, but, interestingly, the Middle East’s rig counts have remained stable. The supply of oil coming from the Middle East has not adjusted significantly downward to reflect the lower demand coming from a weakened global economy.
Why Keep Pumping When Oil Prices Are Low?
The Middle East’s oil producers continue to produce oil below production costs in order to take global market share and to maintain their global oil monopoly during this economic slowdown. Further, the Middle East is concerned with the U.S.’s dramatic rise in oil production. As you can see in the EIA graph below, U.S. oil production has reached levels not seen since the 1970s, pushing the U.S. to become a global leader in energy production. During this global economic downturn, the demand for oil has fallen and OPEC has continued pumping to decrease the cost of oil for all market participants, including the U.S.
When the price of oil is lower than the cost of production, it makes economic sense for oil producers to cap rigs and stop producing. The U.S.’s rig count seems to make it clear that U.S. oil production has peaked.
What Happened to the Oil Market of the 1970s?
A dramatic drop in the price of oil caused many U.S. producers to close down production and some even went bankrupt. Then the OPEC oil embargo of 1973 occurred, during which OPEC decreased supply in an already tight global market, causing oil prices to skyrocket from $20 per barrel to $110 per barrel in ten years. The rapid rise in the price of oil triggered a financial meltdown in 1973 and almost all sectors of the economy suffered from a rise in production cost.
The Bottom Line
Just recently, Royal Dutch Shell warned of a looming price spike in the price of oil. Investors should watch closely as this global drama slowly unfolds and make sure to position themselves to profit from increased volatility in the global energy complex.
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