Monday, September 15, 2014

Where is the floor for the price of oil?

Oil prices (WTI crude as a proxy) are close to $90 per barrel this morning, down from almost $110 earlier in 2014. $90 is also major trend line support (see chart below).

This is despite global unrest in Russia, Ukraine, Syria, Iraq and elsewhere. As I have mentioned before (see charts below or click link), wars over the past 30 years have generally been negative for oil prices, even when, and sometimes precisely because, oil producing and exporting nations are involved.

Over the short term (next 3-6 months) it looks like oil will continue to head even lower due to weakness in Chinese and EU oil demand and there are three levels which have to come into play to define the downside:

*1. Marginal Producers: At what price do the global marginal high cost oil suppliers, currently US tight oil (fracking) producers, begin to shut in supply and stall exploration activity? The general assumption is that this begins in the mid to low $70s per barrel (basis WTI crude).

*2. Consumers: At what price do oil consumers increase their consumption? Consumer behavior changes slowly over time with respect to oil - this is why oil demand is called inelastic. Oil prices have to go to extreme levels to change consumption behaviour - hence the rally to $150 in 2008 required to stall demand in the face of insufficient supply growth. So although lower oil prices will likely increase demand above historic patterns, this is likely to occur only over the longer term (3-5 years). So count this factor out for a hard floor level in the short term.

*3. OPEC: At what level will OPEC (which just means the Saudis these days) act? The Saudis already say they are cutting supply. However, they are still only matching reductions in demand growth and have yet to get ahead of the curve. The Saudi budget break-even is currently in the high $70s per barrel. This is the level below which the government there has to start borrowing money to pay for schools, roads, defense and so on.

So the mid to high $70s may be the first floor to be tested. That is the level at which US tight oil producers and OPEC (Saudis) have to begin reacting by cutting supply to match the lack of robust oil demand growth.

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