The surprise is less that the oil price has crashed than that it took so long to adjust to a technology led supply shock; global oil supply was 2.8m bpd higher y/y in September and US output reached 8.8m, while global demand growth is down to about 700k bpd. I’ve been consistently bearish since January with a $95/bl fair value target on Brent on a rising global supply cushion and weakening EM demand growth. The correlation of the latter with Chinese fixed asset investment is strong – demolishing old structures, making cement and steel rebar and transporting them to site is the most energy intensive part of the Chinese economy and IEA demand growth forecasts have been relentlessly downgraded since June.
Over the past couple of weeks, the oil selloff has been one element in the interplay of structurally low liquidity and cyclically high portfolio leverage, as hedge fund value-at-risk model herding has unwound violently. The $600-700bn windfall for oil consumers from current prices sustained for a full year would have a powerful multiplier effect in the real economy, and certainly far more so than an equivalent dose of further QE via asset reflation. An oil price averaging $90/bl would directly shave 50bps off global CPI inflation over the next year, taking us to the lowest levels since 2009 (already the case for EM) and probably delaying Fed action to H2; the anticipated BOE tightening cycle is already slipping to late 2015.
However, it also adds back the 40-50bps of US GDP growth in 2015 the YTD dollar rally was set to subtract, so leaving the Fed’s outlook broadly unchanged on growth if not inflation. The soaring real cost of oil was a major drag on US consumers in 2002-8 and source of distorted capital flows, transferring trillions of dollars across the global economy from ‘spenders’ to ‘hoarders’, fuelling the US credit boom and very directly precipitating the sub-prime crisis as paying your mortgage or filling the gas tank for millions of low income/ high leverage households became a tipping point for the US economy. That dynamic will now work in reverse; meantime, OPEC’s pricing strategy seems to be undergoing an historic shift in response to its loss of market share to the US. At this stage, Saudi would historically be slashing export volumes but seems intent on pushing prices toward US shale oil’s average marginal cost of $70-80/bl (wellhead marginal costs can vary widely even within individual fields), curtailing the $200bn in annual energy capex driving the US emergence as the world’s largest liquid energy supplier.
Shale output growth is likely to slow modestly to maybe 750k barrels next year at current prices from previous expectations of 1m, but it would probably require sustained prices closer to $70 or below to eliminate US supply growth. Fiscal breakeven prices are over $100/bl in Saudi and an average of $95 across the Gulf producers on a post Arab Spring social spending surge. With ample reserves ex the basket cases like Iran and Venezuela, the competition for market share within OPEC seems the key near term political focus. The oil market now looks rather like iron ore, with BHP/Rio trying to force high cost Chinese capacity out of the market by flooding the market and crashing prices. Overall, the oil reversal will achieve what QE has failed to deliver via the ‘portfolio channel’ effect of asset reflation i.e. boost the spending power of lower income households in the US and elsewhere with a high propensity to consume.