The current decline in oil: Investment and macroeconomic considerations.

Abstract

Over the past several months, the price of oil has declined precipitously. From a high of $145 per barrel in July of 2008, the price of oil has now declined to below $50 per barrel at the time of this writing. The correlation with the performance of the Canadian market has been striking. Current news reports focus on the decline in Canadian securities performance as a reflection of weakness in the oil market. Given the cyclical nature of the securities market and the commodities market, questions arise as to whether the price of oil has reached its nadir and whether the current environment represents an opportunity to purchase oil-based products as part of a value-accretion strategy. How is oil traded Oil is is regulated by the Commodity Futures Trading Commission and is usually bought as a derivative product. In most cases, oil is purchased as a future contract. This contract entitles the purchaser to buy the security at a future date at a specified price. It is typically traded by two broad classes of investors. The largest class has interests in the oil industry. They are trading as a hedge against price fluctuations. Airlines, manufacturers and others who use oil as a factor of production use such contracts as a means of providing predictable supply at predictable prices. The second class of individuals who purchase such contracts are speculators who seek to profit from fluctuations in market price. In most cases, such speculation is confined to the contracts themselves and no delivery is taken of the commodity. How is the price of oil determined? There are three primary factors that influence the price of oil. The first is market demand. Energy demand is often conceived as a proxy for economic and manufacturing activity within the economies of various countries. Aggregate output has begun to slow worldwide. While gross domestic products continue to rise slowly, the rapid growth witnessed in some countries has slowed. This has been especially true in China, where demand for oil has plateaued. As economic growth has been curtailed, the effect is a reduction in demand for energy and for oil. In more developed countries, there has been a shift toward alternative energy production, thus decreasing demand for carbon-based energy. Such reduction in demand has a negative effect on price. Supply is the second determining factor. Supply is often determined by the cost of production in the short and long term. The cost of production varies depending on the cost of extraction and processing. The cheapest cost of production is in Saudi Arabia and Libya, where production can be as low as $5 per barrel. However, production costs reach a zenith of $90 per barrel in some oil sands developments. In the short term, supply can be adjusted to reflect immediate demand. However, this becomes more complicated in the long term. Decisions regarding infrastructure are made in anticipation of future prices. Once committed, much of this infrastructure is built regardless of the current price. Decisions regarding operations occur at the margins, thus promoting production once large capital costs have been incurred. The overall effect has been a significant increase in supply. Large investments in infrastructure have been made by ‘fracking’ firms. Fracking in the United States has significantly increased the supply of domestic oil. While the United States does not export oil to any significant degree, it has curtailed its import as the result of domestic production. Supply has also expanded as the result of geopolitical factors. The current conflicts in Iraq and Libya have not curtailed production to the extent expected, thus increasing global supply. Finally, there has been no move by the Organization of the Petroleum Exporting Countries to reduce production by its members to stabilize price. They are continuing to produce in an effort to maintain market share. The cumulative effect has been a highly significant increase in supply. The third ingredient is deemed by most experts to be market sentiment. As the name implies, there is very little certainty associated with these fluctuations. While market fundamentals may be held constant, in some circumstances, volatility may result from increased speculation and macroeconomic predictions. The source and result of these sentimental shifts remains elusive and exceedingly difficult to predict.