How crude oil may be moving towards a new normal in pricing

An oil price crash typically throws up familiar comparisons with 1986, 1998 and 2008. In all these 3 periods, oil had corrected for a fairly long time but had managed to subsequently bounce to new highs. The 2009 oil price crash was caused by the global slowdown post the Lehman crisis. The 1998 oil price crash eventually led to the Russian default. The 1986 oil price crash was, perhaps, similar to the current situation as that too was caused by oversupply coming in from Latin America. The question is whether this time around oil will bounce back to its highs? Or, will it remain at depressed levels indicating a new normal for oil pricing? There are sufficient indications in the oil market to suggest that we could be seeing the beginning of a new normal in oil prices.

A new swing producer in the oil market…

In the oil market, OPEC dominated oil supply and pricing for over 4 decades. To a large extent, the largest oil producer within the OPEC, Saudi Arabia, continued to be the swing producer of oil. A swing producer is one who can easily tweak supply so as to directly impact oil prices. A lot has changed in the last couple of years. With the share of OPEC just about 30% and the US and Russia producing as much oil as Saudi Arabia, things are changing. The US with its vast shale reserves and production flexibility has emerged as the new swing player. With Saudi Arabia no longer the key swing player, it is not interested in tweaking supply any longer. That could be one of the reasons for the new normal in oil.

Supply as much as you can…

The focus of most of the OPEC members seems to be to keep the supply taps running so that market share can be maintained. The US dependence on the OPEC has reduced substantially and it is likely to become self-sufficient in hydrocarbons by next year. The OPEC needs to find alternate markets to absorb their output. Saudi Arabia, the key driver of the OPEC, has also lost its pricing power because African countries like Nigeria and Angola are willing to offer much more flexible spot price contracts. The priority for the OPEC seems to be to supply as much as they can in as short a time as possible.

Demand is shrinking and will remain shrunk…

The demand for oil has been shrinking for a variety of reasons. In fact, after demand for oil peaked two years ago, global demand has been consistently falling. Firstly, falling growth rates across Europe, Brazil and China means that oil demand will remain low-key. Secondly, there is a move towards more fuel-efficient cars which can give more miles per gallon. Interestingly, this trend is here to stay and is not relenting despite low oil prices. Thirdly, Chinese manufacturers have brought down the alternate power equipment manufacturing cost to all time low levels. At these levels, it is actually possible to produce and supply alternative forms like solar and wind energy profitably. It looks like the only way oil demand can move; is down.

In a nutshell, oil may defy the previous trends of bouncing back. In the past, oil price recovery has been linked to a core reason. The 1986 crash in oil, led to the collapse of the Soviet bloc and that supply disruption led to a rise in prices. In 1998, it was the near default of Russia which resulted in oil prices bouncing back again. In 2009, it was the liquidity fuelled boom by central banks that led to the recovery in oil prices. This time around could be quite different. The oil production is divided among 3 powerful segments viz. OPEC, the US and Russia. Neither will be in a position to exercise complete control over oil prices. As the world approaches the climate challenge of moving towards a fossil-fuel free world, OPEC will want to make hay and drill as much oil as possible. Hence supply glut will remain for quite some time to come. Lastly, while demand may eventually pick up, the shift towards alternate energy seems to be an economically rational move.

All these factors may only imply one thing. Oil prices may actually be getting ready for a new normal of weak prices for the foreseeable future.

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