Three thoughts on the recent oil price correction

    • Crude oil price has crashed 72.3% to multi-year low of $29.4
    • Current oil price crash is similar to the 1986 Saudi Arabia-initiated correction.

Thirty-year chart of crude oil

3 yr chart of oil

Source: Bloomberg

  1. The big oil splash

Since the June 2014 peak of $105.37, crude oil price has crashed 72.3% to multi-year low of $29.18. The current correction has happened in two waves: the first wave was a nine-month decline of 54.8% from June 2014 to March 2015 and the second wave resulted in 50.9% slump from June 2015 to mid-January 2016.

2. The removal of “Saudi floor” and parallel to 1986 Oil Crash

Among the key factors driving the steep correction in oil price, the removal of “Saudi floor” was an important one. Saudi Arabia has explicitly stated that it will not cut back its own production in order to maintain high oil prices. As a result of this, supply and inventory continue to build up despite the steep fall in oil prices. The global supply growth increased by 2.6 million BPD (barrels per day) in 2015. On the other hand, global demand growth is only at 1.8 million BPD.

The correction was further exacerbated by the negative feedback loop; oil exporters witnessed huge drop in their currencies and were forced to sell US Treasuries to bridge their fiscal shortfalls which put upward pressure on US interest rates and cause oil prices to correct further as the US dollar gain strength.

The current episode of oil price correction is similar to the 1986 Saudi Arabia battle for market share. In 1986, Saudi Arabia unexpectedly ramp up production to fight for market share against the North Sea and Alaskan producers. The North Sea and Alaskan producers were the equivalent of US shale oil producers today. After Saudi Arabia declared its intention to increase production in December 1985, oil price had a steep decline of 65.0% for four months to a low of $10.42 in March 1986.

      3. Are we close to the bottom?

Using history as a guide, we seek to estimate where crude oil prices (WTI prices) will trough. The current episode of crude oil price collapse is the biggest slump in the past thirty years, exceeding the 70.2% decline during the 2008 Global Financial Crisis.

Therefore, crude oil price should probably find support at the current $29 handle. At below $30 crude oil price, only a third of global oil producers will be able to generate positive cash flow. Thus, this will likely lead to rationalization in the industry and the resulting pullback in production will provide support to oil price. However, if there is further economic slowdown in US and China, crude oil price may potentially overshoot and reach $26.9, similar to the 54.8% correction it witnessed in its first wave of correction starting in 2H2014.

 Major oil collapse in the past thirty years

oil table

Source: Bloomberg

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