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Concerns over the Cost of Oil

July 28, 2015 - Kestrel Management

Recently, Kestrel Management sat in on the webinar 85 Dollar Oil (per barrel) by End of Year presented by Rick Bobigan, adjunct professor at the University of Texas – Austin. The webinar addressed a few key questions—questions that we know are top-of-mind for our oil & gas and chemical clients:

  • Why did the price of crude fall and why is it still declining?
  • Where is the bottom?
  • Will prices return to the $85-90 range and, if so, when?

Why did the price of crude fall?

In a nutshell, Bobigan explains that the price of oil has dipped due to a few key factors:

  1. S. dollar – The strength of the dollar has increased relative to other currencies (a dollar, therefore, buys more goods).
  2. Supply risk concerns – Buyers see the downward pricing trend and wait to purchase the good until it hits its lowest value, causing supply to exceed demand.
  3. Changes in supply and demand – A recent OPEC meeting discussed the oversupply of oil in the market from horizontal wells and oil shale compared to the consistent 1-2% annual increase in demand.

In the CNBC article Never mind Iran. Oil price is going nowhere (July 14, 2015), Signal Analytics CEO Stephen Davis also emphasizes the role of the global economy in driving the price of oil. A Reuters poll of 25 oil analysts forecast Iran could raise crude oil output by up to 750,000 barrels per day (bpd) by mid-2016; the global crude market already has a 2.6 million bpd surplus.

Davis goes on to state, “It’s not just that supply is moving up way more than it should, but it’s that demand is potentially weaker than people think, so it’s actually the worst of both worlds” when it comes to the dropping price of crude.

According to Signal’s analysis, demand from China has an almost 50% correlation to the price of oil—and China’s economic growth is forecast to be the weakest since the global financial crisis of 2008-2009 (CNBC, 2015).

Will prices return?

Oil prices fluctuate due to changes in supply and demand, currency valuations, supply risk, and the global economy. The amplitude of the price cycle depends on strength/weakness of these factors in relation to one another.

Bobigan believes that the return of oil prices will depend, first, on a weakening U.S. dollar. Once buyers see that price is increasing, many will act decisively to stock up and create a mini-shortage (i.e., greater demand). The premise for this recovery is that the cycle will mirror the 2007-2009 price cycle and that equilibrium will eventually be established at a higher price.

In addition, the supply of oil shale will diminish, and Bobigan believes that will also contribute to a rebound in oil prices. Oil shale is a more expensive method of crude extraction and, therefore, isn’t worth pursuing when the crude price is so low. Once this supply is removed, demand will begin to exceed supply and drive prices up.

As for the future of the global economy, that is still a somewhat unknown variable that will continue to impact oil prices, for better or worse.

 Submitted by: Will Brokaw

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