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Tuesday, February 2, 2016

What Is Keeping The Oil Prices Low?

While the last two years altogether have been a volatile period for oil prices globally, they have been in a free fall since the last quarter of 2015. Benchmark Brent closed at $33.10, while WTI closed at $32.30 on last Wednesday, January 27. The prices have fallen by about 70% from June 2014 peak prices. [May 2016 Update: July Brent is trading at $49.35, while June WTI is at $48.30. Read our update synopsis] Interestingly though, the supply side players do not appear to be relenting anytime sooner. In fact, analysts expect that the production is going to increase in near term, pushing the prices down even further. So, what is really going on with the oil industry?

Drivers of oil prices
 
Like any other commodity, crude oil is also subject to demand-supply dynamics. Simply put, when production goes up or demand goes down, the global prices fall. But that is not the end of the story. The market players fully appreciate how the current global economy depends upon this fossil fuel and this gives rise to speculation. Oil prices are set at the major exchanges, ICE Futures in London (Brent) and Nymex in New York (WTI), which include a large share of speculative push. It is estimated that roughly 50% of oil prices we see today is pure speculation! 

 
How is Oil Price Really Determined?


Oil Price Trend Update 


The major chunk of the derivatives market is driven by a handful of global banking giants and therefore, system runs heavily on market sentiments. The prices so determined form the basis of crude oil pricing in international markets. Many oil producers use the Brent.
 
The Slump
 
When there is a positive sentiment around demand and supply of crude oil, the big bankers take huge future positions in expectation of speculative gains. This plays an important role in pumping prices, which in turn, attracts greater market activity trading and adds to the rally.
 
The current slump is largely attributed to the likelihood of a plunge in future demand and existing oversupply in the market. Some of the big consumers, such as China, are grappling with an impending slowdown. Bad news is trickling from the other corners as well. On the flip side, the present industry scenario is marked with intense competition between oil producing companies. Everyone is eyeing a bigger share in the pie even if it means stretching beyond the resources for the time being. It's a no-brainer that a cut in production will have a salutary effect on the prices, but the individual producers and OPEC are playing the waiting game to see who yields first. Unless there is a consensus, it is a high probability that those who reduce their production will lose market share to those who do not follow the suit. According to OPEC President Emmanuel Ibe Kachikwu, "We just felt comfortable to wait and watch." The group believes that even a 5% cut is not going to have much impact and is blaming shale oil for the fiasco. To add to an already complex situation, with the lifting of economic sanctions, Iran will soon amp up its production. However, the OPEC decisions cannot be considered representative of all the members because not everyone has an equal say and the organization is dominated by top couple of players.
 The Impact
 
Obviously, the importers and end users are rejoicing. But the gravity of the situation on the other end can be understood by the fact that the oil industry has lost some 250,000 jobs worldwide. While the big energy companies are feeling the pinch, some smaller players along the value chain have already gone under.
The wait and watch policy will not be sustainable for the market players and economies of the oil producing nations as a whole. The current levels are hovering much below the prices that even the best placed producers require.
It is difficult to predict as to how long this stalemate will remain, but most analysts are of the view that if this trend continues for long it might have a ripple effect on the world economy.


Eurion Constellation is a research and consulting firm serving businesses in U.S., Europe and India. The research services have a global reach with focus on industry / market / economic research, financial analysis, equity research, company valuations and report writing. The consulting wing in India focusses on the startup and SME sectors. Please feel free to get in touch for any business requirements. Visit http://www.eurionconstellation.com

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