What Is Happening With Oil?

What Is Happening With Oil?

Oil collapsed further yesterday, dropping all the way to the low-$81 level. We and others have been pointing to the decline in oil as a potentially worrisome sign about the state of global growth, but you don’t have to work on a physical oil desk to figure out that, with oil falling through the floor, something else is going on here.

Both supply and demand influences are pushing oil prices lower.

On the demand side, foreign oil demand is falling. Yesterday, the International Energy Administration (IEA) significantly reduced expected oil demand growth for 2014—down to 700K barrels per day, from the previous 900K b/d. Although they kept 2015 demand growth estimates unchanged, it’s still a large reduction.

The main reason behind that demand-growth reduction is a drop in economic activity in Asia (mostly China) and Europe. Both economies are losing positive momentum (one slowly, one quickly), but these aren’t exactly new facts, and this demand reduction by itself isn’t responsible for the sharp drop in WTI crude prices.

There is also a significant supply aspect to this drop, but likely not the one you think. Simply put, OPEC is starting to fracture, and it is sending Brent crude, which is what’s traded globally, falling sharply. Last month, despite falling prices, OPEC increased production to a 13-month high, led by Saudi Arabia. In addition, Saudi Arabia is now cutting prices to multi-year lows for Asian and European buyers to maintain market share. And, it’s sparked a bit of a price war. Over the last week, Saudi Arabia, Iraq and Iran have all cut prices to buyers to try and compete on market share, and that is driving the price of Brent crude sharply lower (from $113 to $84.50 over the last 3 ½ months, or a -25% drop).

So, this recent plunge in oil prices has largely been a Brent crude-led phenomenon.

That’s important, because our firm and others are trying to figure out if the plunge in WTI crude prices (which is produced here in the U.S.) is reflecting a slowing of our economy, and basically the answer is “no.” WTI has fallen in sympathy with Brent crude, not because U.S. demand for oil is falling. U.S. demand isn’t falling – it’s still sitting basically near all-time highs.

Now, the direction of oil prices is very important to the stock market on a sentiment basis, so I’m not saying we can discount this plunge. And, I do not believe stocks will bottom until oil can stabilize.

But – in addressing the important fundamental question of whether or not the plunge in oil is a warning sign on the U.S. economy, the answer is “no.” It’s more a sign of dysfunction at OPEC, which could be a virtuous thing down the road.

Finally, the logical question then is, “Are oil stocks a buy here?” No, I don’t think yet, as the chances of a further decline in oil prices are high. But, certain sectors of that market (low-cost, lower-leveraged domestic oil and natural gas producers, and select oil service stocks) will be fantastic buys. But we’ve got to be patient and let this OPEC spat settle itself out – because if they want to drive oil lower, they will continue to succeed.

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