The sharp drop in oil prices in recent days has been weighing on markets in the last few sessions. Pre-open sentiment appears to be indicating a positive open, with strong retail sales reading helping the mood.
The forces pushing oil prices down are multiple which likely give the downtrend more staying power. In addition to the well-understood U.S. shale-centric supply side of the oil equation, we have the demand angle where China’s weak growth outlook is having a bearing on consumption. And on top of these fundamental forces is the exchange value of the U.S. dollar, which has steadily been strengthening lately due to divergence in global growth and monetary policies.
On the supply side, production from shale basins has made America a growth region in the oil patch, limiting OPEC’s ability to control the commodity to the same extent as it has in the past. The cartel decided not to implement a supply cut at its recent meeting in the likely hope that the resulting price drop will be even more painful for the higher-cost shale producers in the U.S.
OPEC’s thinking is correct, but the problem is that low oil prices have almost no impact on existing shale volumes. Operators can forego the capitalized costs of finding and developing new reserves as sunk costs as long as prices are high enough to cover cash costs.
[Listen to: Joseph Dancy: Crude Oil Markets Surprise Analysts and Investors]
As such, oil prices will need to drop much lower, perhaps into $30’s, to halt production altogether from existing shale wells. What this means is that prices around current levels will force companies not to sanction new projects, as we have started hearing from the likes of ConocoPhillips (COP), EOG Resources (EOG) and others already.
But it wouldn’t stop their producing from existing wells. Lower for longer will bring about the needed market adjustment where lack of new projects will eventually crimp supplies enough to bring the market back in balance.
The demand side is very hard to handicap given the complexity of keeping tabs on the growth picture of China and other major emerging markets. The U.S. economy is certainly doing better, with the picture improving on the margin as a result of the falling oil prices.
This morning’s better-than-expected Retail Sales numbers reconfirms what we have been seeing consistently in recent months – that being the U.S. economy accelerating to a ramped up growth pace even as its trading partners in Europe, Japan and China losing steam. It is this improved growth picture that prompted the Fed to end the QE program; the Fed is also getting ready to change its monetary policy stance in the not-too-distant future.
Media discussion about the FOMC dropping the ‘considerable time’ phrase from its statement next week is part of those expectations. The resulting strength in the U.S. dollar relative to all other currencies is having an impact on oil prices as well.
