Why Oil Prices Have Plummeted

There are many factors influencing oil prices, but the immediate cause can be distilled down to record levels of crude oil in storage.

As a long-time investor in the energy sector, the current quarter has been one of the worst I can recall. It seemed like the market had turned the corner in 2016 when energy was the top-performing sector following two difficult years, but the price of West Texas Intermediate (WTI) is now down 20% from this year’s highs. Many are wondering why the bear market has returned.

There is one fundamental reason for the weakness in oil prices and that is record global crude oil inventories. These record inventory levels resulted from two primary causes. The first is that since 2008, the U.S. shale oil boom has put about five million barrels per day (BPD) of additional oil on the markets.

The market largely discounted this unexpected surge of U.S. production, and crude oil prices held steady at around $100/bbl for far longer than they should have. Lingering high prices worsened the oversupply situation by keeping too much marginal production on the market.

But in mid-2014, the market could no longer ignore growing crude oil inventories, and oil prices finally broke decisively below $100/bbl. In November 2014, following a $25/bbl decline in crude oil prices, OPEC decided that instead of attempting to balance the market, it would defend market share. Over the next two years, the group added two million more BPD of crude into an already oversupplied market.

Even though global crude oil demand continued to grow at a healthy rate, it couldn’t keep pace with the surge of production from U.S. shale producers and from OPEC. The world built a massive oversupply of crude oil, and that oversupply just continued to grow. OPEC finally reversed course in November 2016 and instituted production cuts, but at the same time, U.S. shale oil production — which had dipped in response to low prices — began to bounce back.

Several fears will likely drive the market for the foreseeable future. One is that crude oil inventories will remain high for a long time. Thus, the upside potential for an investor is limited. Second is that U.S. production gains will nullify the impact of OPEC’s production cuts. Should that happen (and it may), then OPEC is going to have to decide whether to make deeper cuts or return to the strategy of defending market share (which could send oil back into the $20s).

Further weighing on investors’ minds is the constant drumbeat of stories suggesting that the world is on the cusp of peak oil demand. In that scenario, oil prices may never recover. (That’s certainly not something I believe; see my previous Forbes article Peak Oil Demand Is Millions Of Barrels Away).

The peak demand belief is that in essence alternatives to oil will soon result in falling demand (as has been the case in the coal industry), which will render oil far less valuable. That this belief is helping suppress oil prices is somewhat ironic, considering that a decade ago peak supply fears helped drive up the price of oil.

Global inventories will be impacted by OPEC’s cuts, gains in U.S. shale production, and increases in demand. I can rationalize why I think the impact of growing demand and OPEC’s cuts will trump the growth in U.S. shale production, but the theory ultimately has to manifest itself in lower inventories.

Conclusions

So the bottom line comes down to crude oil in storage. What the market needs to see are major reductions in crude oil inventories, but that’s going to take time. Inventories are coming down, but in a bear market like this bad news has a far larger impact that positive news. The bullish news of five straight inventory declines can be undone by one surprise inventory build, sending prices reeling.

That’s likely to be the status quo for a while. It’s hard to say where the bottom is on oil prices. The current price is unsustainable long-term for producers (long-term investors take note), but the only thing that’s going to turn this market around is lower crude oil inventories.

1 thought on “Why Oil Prices Have Plummeted”

  1. People make too much out of the storage issue because it is something we have data on. At the end of the day, supply and demand are what matter. Storage is just temporary issues with production and consumption mismatch. But at the end of the day the cost curve for production and the demand curve for consumption are what matters. If overall demand drops, price will drop. If overall supply increases price will drop.

    The storage issue might explain the prompt month a little. But it doesn’t explain the whole strip dropping. That reflects a belief in lower for longer and in the strength of shale.

    Look at what the US started doing at $53 bucks. The market can’t tolerate an extra MM bpd a year from one country. It just can’t. So price dropped to restrain shale. And it will constrain shale. This is really no different from what we have been seeing on/off since 2014. Shale kicks ass. Drill baby drill was right.

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