The Crude Reality. Part 2

When the laws of supply and demand ceased to function
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Anyone who took economics 101 in college knows that at a lower price, consumer demand for a product increases, pushing the price up; and at a higher price, demand slows, therefore depressing the prices. On the producer side, higher prices incentivize producers to supply more products, while lower prices have the opposite effect.

Well, all that’s gone out the window in the past year or so.  In the current crude oil market environment, the supply-demand relationship is so out-of-whack, that it would have sent Adam Smith into early retirement.

As the US becomes more energy independent and China faces a reduction in growth, demand for crude oil from traditional sellers shrunk.  Under normal circumstances, producers would reduce or stop the supply of oil until the price recovers, but that is not the case.  All of the oil producing countries have kept pumping at the same level.  Their rationale varies from country to country:  For Saudi Arabia and its rich Gulf neighbors it is evident that they can keep making a profit even at low prices, and maybe get rid of some competitors in the process.  For poorer countries there is no alternative, now that they are getting less dollars for their oil, they can’t cut production because it would harm them even more.

There are several factors preventing cuts in supply:

  1. Fear of losing market share.  In the current environment, where producers are fighting for their market share, it is very unlikely that any oil producing country will be willing to unilaterally cut production, which will allow other countries pick up their slack and fill in for them.  Recovering its market share could prove a very difficult task indeed for any given country.
  2. Fear of a shrinking market.  There are so many different types of alternative energy being currently tested, that it is unclear whether in the near future any of these could present a breakthrough and push oil out of the way.  Should this happen, producing countries would be left sitting on a pile of oil nobody wants.  They feel that if oil prices stay depressed for too long, there might not be a recovery.
  3. Lack of unity among oil producing countries. Both OPEC and non-OPEC members could have agreed months ago on a way to cut production across the board, while maintaining the same market share percentage, but that hasn’t happened. Despite Venezuela holding bilateral conversations with several countries in the recent days, there doesn’t seem to be any consensus.

So we are faced with a dichotomy, where lower prices are not increasing demand, and are not reducing supply.  Should this be sustained we could face low crude oil prices for a long period of time.

On Friday, the WTI March contract soared 12% on news that the UAE is open to production cut talks, and although the market evidently gave the news more weight than it did Venezuela’s earlier in the year, we will need to wait some time to determine whether this constitutes an actual trend reversal since the fundamentals are unlikely to change in the near future.

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