Oil price not sensitive to demand – Part 1

It is a well-known fact that the oil price has a significant impact on global financial markets and hence also on the global investor. It is therefore important to understand what is currently happening and how this may impact markets going forward. Many commentators claim that the collapse of the oil price is due to a global oversupply.
Let us therefore look in more detail at the global supply/ demand situation as illustrated by the below graph. It reflects the 12 month average world oil demand as a ratio of the 12 month average world oil supply, as published in the latest ‘Energy Briefing’ by Yardeni Research Inc.

benchmarks-janfeb-graph1

12 month average world oil demand

Clearly if this information is to be believed there is actually still an oversupply of crude up until November 2015 although on a steeply declining trend. So it is probably true that the oil demand is slowing as the result of slower global economic growth. However, the global economy is still growing even if only at a slower pace – China ‘only’ at somewhere around 7%, meaning that the global oil demand should still grow and it does rather liberally as reported by Yardeni . What about oil supply which is said to be increasing? This is also not really a convincing story, if one looks at what is happening in Iraq, Syria and Libya. Now lets us look at the relative movement in the spot oil price per below graph and try to overlay this onto the demand vs supply graph above.

Relative movement in the oil spot price

Relative movement in the oil spot price

For the first few years from 1994 until 2004, the two graphs show a reasonable correlation between the rate of crude oversupply and its price. When the rate of crude oversupply peaked abruptly in 2002 – 2003, the oil price hardly moved.
As the rate of oversupply gradually declined from the end of 2003 to the end of 2013, the oil price peaked and troughed abruptly in the course of 2008 to then continue on a steady upward trend from where it last ended in the middle of 2006, to collapse by the end of 2008. From the beginning of 2009 up until the end of 2014, there appears to be a negative correlation between the rate of oversupply and the price of crude where oversupply declined systematically while the oil price increased systematically. The graph depicting the relative spot oil price movement thus indicates that since 2004 the oil price moved up sharply for reasons unrelated to the rate of crude oversupply, remained at inflated levels barring 2008 and that the more recent collapse of the oil price is merely a correction of an inflated price of crude up until the middle of 2014.
So if the oil price is driven by factors other than the rate of oversupply, the obvious question is what drove the oil price to and maintained it at its lofty heights for the 10 years from 2004 to 2014 and what caused the reversion of this? After the oil price started its decline there was wide acknowledgement that hedge funds were largely responsible for its lift-off and it is then also the only plausible explanation for its recent collapse as well. As oil is a significant component of commodity hedge funds, we saw commodities’ general lift off until 2014, and we also saw them collapse in unison with the oil price. Since both SA and Namibia are commodity based economies this has already impacted our economies quite badly. The question arising is whether the current price level of crude is sustainable, whether this state of affairs will continue and if so, for how long we can expect it to continue? We have seen that the speculative underpin of high commodity prices has been sustained for a period of 10 years. This indicates that the reversal of this, assuming a constant crude price of 30 Dollars per barrel, could prospectively also last for a period of 10 years until equilibrium has been reached once again. Our calculations indicate that on a US CPI adjusted basis the oil price should currently be around at least 35 Dollars per barrel. It is to be noted though that this calculation ignores changes in technology on the one side, and the depletion of conventional crude resources on the other side, that impact cost of production. So any price below 35 Dollars per barrel is definitely unsustainable in our view. In fact going by the cost of production in the main oil producing countries as reported in the media, a price below 70 to 80 Dollars is probably unsustainable.
Part 2
Continued next week with correlation between the Rand/US Dollar exchange rate, the oil price and the SA Allshare index.

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