Increasing Production Continues to Drive Oil Prices Downward

Oil

While oil prices have been in an upward trend since late December of last year, tracking the stock markets pretty closely, it is now experiencing its biggest pullback since the rally began.

The price of oil and the price of stocks are somewhat positively correlated, but to look at this relationship over the last 6 months, you would think that the correlation is very high. The stock market has in fact eerily moved in the same direction as oil has during the fourth quarter pullback of 2018 and during the rally of 2019 as well.

Quite a few stocks peaked and bottomed on the very same days as the stock market did, starting to fall on Oct 4 and bottoming out on Dec 24. This is also the top and the bottom of the move of West Texas Intermediate, to the exact day. The direction and magnitude of the moves have also been very similar.

Oil was at its high of the year on April 23, but has been pulling back since. This move down has been the biggest we’ve seen since the rally in oil prices started late last December, and while this hasn’t been enough to suggest much in terms of a trend reversal, at least in terms of the chart data, when you lose 8% in a little over a week, that is a move of some note at the very least.

Demand for oil does change over the long run, but not so much over the short term, and the price of oil is famously driven by the supply side, often intentionally. As we increase or pull back on oil production, which is very easy to do, the price will follow.

Right now, we’re seeing production increase in the short term, particularly from the United States, which is becoming a bigger and bigger player in the market as time goes on. The U.S. has climbed to the top of the heap now, and have passed both Saudi Arabia and Russia as the world’s leading oil producer.

This has really changed the dynamics of the oil business. Where OPEC once held most of the power in controlling oil prices, we now have two new big players on the scene, the Americans and the Russians, the top 2 countries in the market, and they do tend to dance to the beat of their own music.

America Continues to Increase Their Production Capacity

American oil production is currently at an all-time high, and is still growing, which means downward pressure upon prices. The American scene is much more of a laissez-faire economy than the calculated moves of the Arabs that we have been used to seeing for so long. One of these moves by OPEC was to drive the price of oil down enough to try to drive away a lot of America’s supply, which is more expensive to produce than cheaper Arab oil, but that didn’t work out very well, and the Americans are not only still around but growing larger by the year now.

Both the production of oil in the U.S., now up to 12.3 million barrels a day, and its inventories, which rose by 10 million barrels this week, as well as an expansion in drilling rigs, are starting to weigh more heavily on oil prices, which we saw drop by 3% after the latest data on this was released on Wednesday. Oil was already on the way down and this new information added to the losses.

The price of oil is actually set by the futures market, where suppliers and producers both settle on a price for future delivery. These futures contracts become traded on the futures markets, which allows for greater liquidity and price discovery than with spot trading. This also provides both producers and consumers a means to hedge the risk of future price fluctuations, through this window of price certainty that the futures market provides, making it easier to manage their businesses.

Oil is also used by the United States as a means to manage its foreign policy. We usually think of sanctions as the weapon that is used here, but the U.S. government also has a means to use oil prices themselves as a tool against other countries.

For instance, the Trump administration has recently asked Saudi Arabia to pump more oil to push prices lower, and we might think that is a pretty odd request given that America is the world’s top oil producer now and lower prices for oil would therefore be counter to the country’s economic interests.

The Saudis aren’t having any part of this though, but prices are going down lately, at least over the last week or so. Sanctions in place against Venezuela and Iran have political clout, but they also raise the price of oil as this contracts trade, and we might even view this as a means to manipulate oil prices as well as punish countries that you do not agree with.

Manipulating oil prices is nothing new though and is why OPEC exists, although bringing in geopolitical clout to this game certainly adds interest to it. It is very interesting that the Americans want to push prices down right now. We can’t forget about the consumption side though, and the United States is also the world’s biggest oil consumer, by a good margin, with the European Union being a distant second, followed by China.

The Saudis actually need oil prices to be higher than the United States does, as they learned when they drove oil down to close to $30 a barrel back in 2015. Instead of breaking the back of the American producers, they were the ones that really felt the pain, and this situation continues. When your economy is so linked with oil, there is more at stake, and Arab countries are much more dependent upon it than the United States.

Saudi Arabia is pushing for higher prices now, or at least not see them drop from the higher levels we’ve seen lately, but the days where they and their Arab brothers ran the show have come and gone. However, the expiration of waivers with sanctions on Iranian oil are about to kick in, which will reduce supply by over 800,000 barrels a day, as Iranian supply goes from 1.3 million barrels a day to below 500,000 without the waivers.

We May See Oil Prices Continue to Rise

This might be seen to suggest that prices may go even higher as the year goes on, and that might happen, although the Americans are already taking up some of the slack. The Saudis aren’t interested in intentionally putting prices down when they prefer them higher though, so there was no chance of them complying with Trump’s request to raise production. The U.S. may have influence in Saudi Arabia, but oil simply has more, a lot more.

OPEC’s policy these days is on the side of holding back on production, and some wonder whether the group can stay together on this or if some members might give in to the temptation to ramp things up on their own. Oil at one time provided excesses of wealth to Arab countries, but now it’s much more integrated and there is nowhere near the flexibility there once was, due to their economies being so dependent upon oil to keep their ships afloat.

We don’t want to make too much of this last week in oil prices, as the amount of capacity that we’ll see added will be limited, and there’s also the reduction in Iranian oil that is coming up to take into account. Oil may indeed be headed higher, to the chagrin of the U.S. government but to the delight of the Arabs.

Oil going a lot higher though is probably not in the cards, especially given that the Americans are pumping so much of it. Growing inventories are a bit of a concern, but not so much as to have that great of an effect upon prices, as is a demand side consideration essentially, the demand really doesn’t change that much in the shorter-term. We can therefore just look at production and have a good idea of what is going on.

The trend with oil prices is still upward in spite of this pullback, and we’re still about 33% higher than where we were at Christmas, where we’re up about $20 a barrel from. We still need about $13 a barrel more to get us to where we were last October, so there’s some room for growth here just to recover from the last bear move.

Taking everything into account, oil seems more poised to go up from here rather than down over the next quarter, and this week’s dip may be more of a buying opportunity for traders than the start of a reversal.

Ken Stephens

Chief Editor, MarketReview.com