The US dollar's upside momentum has faded, but oil prices remain depressed. Many observers try, too hard perhaps, to link the decline in commodity prices in general, and oil in particular, to the appreciation of the dollar. Yet the situation is considerably more complicated.
There is a case that can be made that the decline in commodity prices reflects slower world growth prospects in general. Demand in China, the key consumer of commodities, has softened, and its crackdown on using commodities to disguise capital flows, or use as collateral for loans, may also be weighing on demand. This weakness in the global economy stands in contrasts to the US economy, which grew 4.6% in Q2, and appears to have been around 3% in Q3. This contrast, or divergence, has helped bolster the dollar.
However, this conventional narrative does not do justice to the supply side. From a high level, more often than not, dramatic moves in commodities seem to be a reflection of supply shocks more than demand shocks. For example, record harvests in the US explain the decline in grain prices more than the dollar or a slowing of the world economy can.
Oil prices have fallen by 17-20% since mid/late June. There may be some role for the global slowdown and the appreciation of the dollar, but these are not the main drivers. We see two main forces. The first is Saudi Arabia. It usually acts as the swing producer, cutting output when prices are low and increasing output when prices are high. It is not cutting output presently. To the contrary it looks to have stepped up its output. The key question is why?
As in many important developments, this too could be over-determined (meaning more than one cause or consideration). First would be Saudi Arabia's domestic considerations. It depends on oil revenues to finance the government's activities, including a generous welfare program. By boosting output, it can maintain overall revenues in a soft oil price environment.
Second, some suggest may also be a favor to the US in that a fall in oil prices adds to the pressure on Russia. I am sympathetic to arguments that it was the collapse in oil prices more than the Reagan-inspired arms race that ultimately led to the fall of the Soviet Union. While it is possible that Saudi Arabia changed tactics are part of some kind of pact with the US, it does not seem compelling and is contradicted by a third consideration. A decline in oil prices, especially if a move below $80-$85 a barrel can be sustained, it could change the dynamics of the US shale projects.
Fourth, the Saudi oil stance may be a warning shot to OPEC, which meets early next month. By boosting output, it may enhance its effort to reinstate discipline within OPEC. Its internal battle within OPEC means that if it does not pick-up market share, its rival Iran would. Some observers think there is a proxy war of sorts being fought between Saudi Arabia and Iran. Libya and Venezuela domestic considerations do not favor cuts in output. Separately, Russia may also be inclined to step up production to limit the decline in revenues.
The sharp drop in oil prices is also being linked by most to weaker demand. While there may be some role here, we encourage investors to give supply factors their due. As the low cost producer, it will make up in volume the revenue lost by the decline in price. Last week Saudi Arabia reduced the price of Arab Light crude to Asia to six year lows.
Many pundits thought the US was the main loser in the mega-energy deal between China and Russia earlier this year. They are reducing the role for the dollar, was a common assessment. That is a side show and of little consequence as the dollar's appreciation in recent months has demonstrated. Instead, the deal may have opened a new front of competition for OPEC.
Saudi Arabia's decision that leads to increasing its market share intensifies the competition within OPEC. Today, Iran announced it will cut the price of its oil exported to Asia, apparently matching the Saudi's move. This is what a price war would look like and it is squeezing some producers, like Nigeria, already. Next week, Kuwait and Iraq will announce their prices. Not to cut prices, would see them lose market share, but to cut prices feeds the price spiral.
The drop in oil prices can only exacerbate the deflationary risk in the euro area. If sustained, it may also hamper the BOJ's effort to drive core inflation (core means excluding fresh food, not energy) to 2%. In the US, the drop in oil prices, if translated into gasoline and heating oil prices, will help boost disposable income, which may be noteworthy given the lack of real wage increases, and therefore consumption. The Fed targets core inflation (for which core excludes food and energy). Rather than focus on the impact on prices, policy makers would likely focus more on the positive impact on demand.
US output is another supply side shock. In the week through October 3, US crude output was 8.88 mln barrels a day, and for the 48 continental states, it was highest weekly figure since 2010. Since 2008, the EIA estimates that US oil output is up more than 70%. Its 2014 forecast of average daily output in the US this year of 8.53 mln barrels can be surpassed. During that same week, US oil imports were 7.71 mln barrels a day. This is about 1.5 mln barrels a day than the average in the 2011-2013 period. The EIA expects imports to fall to 6 mln barrels a day next year.
Through the week of October 3, US crude inventories rose by five mln barrels. The consensus had forecast a build of a little more than one million barrels. Crude inventories are about 2% above the five year average, and refinery utilization has fallen to the lowest since June.
Talk of peak oil and the demise of the dollar spurred fantastic talk of a return to $150 a barrel and higher. It was supposed to support the shift in the world economic order, leaving aside the fact that China is a larger importer of oil, or that the world economy does better (at least in the short and medium term) with cheaper energy. While scenarios are high oil prices have been gamed out, we suspect not sufficient attention has been given to the opposite, and just as plausible a scenario of a further material drop in oil prices.
The 10-year average (120-month) of WTI is about $82.00 a barrel. In 2011 and 2012, it hit $75-$77. These do not seem like unreasonable medium-term targets. Technically, a break of $73 a barrel could send WTI toward $64, which corresponds with the 2010 low. A break of that would indeed be significant.
