Why are oil prices falling? — energy & politics

What has caused this stunning dive in oil prices? Too much production, to be sure, but a the US-China trade spat with no end in sight, and slowing economic activity—and maybe even early signs of a recession—in China.

Scott McKnight - October 2018

In early October 2018, West Texas Intermediate (WTI), the US benchmark for oil prices, hit nearly a four-year high of US$76.41. Oil traders whimsically talked about the return to $100/b. They aren’t anymore. Late last week (early November) US oil prices hit an 8-month low, officially entering a bear market. The rapid drop in oil prices have oil analysts wondering what they missed—and whether it’s more than just increased production from places like West Texas and North Dakota, but more ominous factors on the demand side like a less voracious oil appetite in China.

This article breaks down the major supply- and demand-side causes of this price fall. First, the obvious one: more oil in the market than expected, especially from US shale producers, but also a softer approach from the Trump administration toward buyers of Iranian crude. Second, uncertainty about where the US-China trade dispute will end up and, more disturbing, long-term slowing demand in China, the world’s biggest oil importer.

The United States became the world’s largest crude oil producer in mid-September 2018. US daily production hit a record of 11.6 million, just a bit more than Russia’s current production numbers and a stunning feat for a country that little more than a decade ago was bemoaning its dependence on foreign oil. Now, with the so-called ‘shale revolution’ and WTI hitting a nearly four-year high (US$76.21) in early October, the United States is producing abundantly from major shale regions like West Texas and North Dakota.

Larger-than-expected US oil production is the obvious reason for the recent dip in oil prices. Another is Iran, where the bulk of US sanctions against the regime were set to return to force on November. In early May 2018, the US had announced its withdrawal from the Joint Comprehensive Plan of Action or ‘Iran nuclear deal’; last week the return to sanctions came into effect. But instead of a harsh stance on all things Iranian, the Trump administration issued waivers—exceptions of sorts—for purchasers of Iranian crude. While it may be a sign that the Trump administration had overplayed its hostile stance to the regime—against the wishes of key allies and their economic interests—the waivers were given to eight countries, including Japan, India and China. The waivers tame fears in the market of an abrupt sanctions-induced supply squeeze—for the next few months anyway (the wavers will last 180 days). Iran is an oil heavyweight (producing about 4 million b/d in 2017, or about 4% of total global production, exporting 2.1 million b/d of that sum). So, allowing even limited amounts of Iranian crude to be sold into the market means more barrels than more dour market forecasts had anticipated, and hence the recent downward pressure on oil prices.

But the recent drop in oil prices is about more than supply. The escalating dispute between China and the United States—a hobby horse for Mr Trump—has market watchers wondering when it’ll end, under what terms, and having done how much damage to global economic activity. Any decrease in trade would lead to an economic contraction and almost certainly to a less intense appetite for oil.

Connected to this pervasive economic uncertainty is a far more ominous phenomenon: an economic slowdown and the early signs of a possible recession in China, the world’s largest oil importer and newest important driver of oil demand in the past fifteen or so years. Chinese government-reported economic numbers, always first a test in credulity and later in tea-leaf reading, have been mixed. Consumption numbers are weak, and this year will likely mark the first year ever when car sales in China didn’t increase.

Something bigger may be happening. In the past two decades or so, when the Chinese economy has slowed, the government hasn’t shied from pulling every macroeconomic lever under its control, cutting interest rates, making lending terms more attractive, and essentially using credit to grow out of the slump. The government tried a similar course this year, increasing liquidity in banking, again encouraging lending to get economic activity buzzing. But, according to insiders, this hasn’t worked—or at least not to the government’s expectations. Investors haven’t jumped to borrow and consumers aren’t spending. Local governments, the key government unit to pump up this economic activity, simply cannot borrow, already overextended and laden with debts from years past. A sense of desperation may be sinking in, and this dip in oil prices may be a hint of something bigger to come.

The recent oil price dip is due to the production, especially from the dynamic shale producers in the United States who, now over the past decade or so, have honed their more manufacturing-like processes and deftly react to market signals. The sale of Iranian oil—more than expected anyway—is another reason for the price drop. But there is more to the story than just too much production. A decline in demand, either temporary or permanent, is without question more concerning. The trade dispute between the world’s two largest economies, the United States and China, has no end in sight. And yet asking when it will end seems secondary to the long-term question of at what cost. That has put a sense of fear and uncertainty into the markets. Connected to this is the state of China’s economy. The transition from energy-intensive industry to a lighter, more consumer-driven economy hasn’t been as smooth as its planners had envisioned, leaving the government to reflexively pump credit into the economy to keep economic activity high. If that strategy has run its course and China’s economy is moving toward a recession, then the current oil price drop is just the beginning.