Oct 28, 2014 | Post by: Roman Chuyan, CFA Comments Off on Oil Price: Beginning Of A Downtrend

Oil Price: Beginning Of A Downtrend

Crude #oil tumbled 8.7% today to a 4.5-year low of $67.34 a barrel after #OPEC decision to maintain its production. As I wrote in November 2013, the downtrend in oil was expected – and it began in September 2014. Here’s why OPEC’s ability to change this trend is very limited.

Supply-demand fundamentals is what drives the price of oil over a mid-term period, 2-3 years. One chart summarizes the most essential data points: the Medium-Term Oil Market Balance chart. The chart, shown below, is produced by the International Energy Agency’s (IEA) as part of its annual Medium-Term Oil Market Report.

Tactical investment management - Energy - IEA medium-temr oil market balance

Source: the International Energy Agency

The chart synthesizes the most essential data points that are critical to supply-demand assessment for crude oil: spare production capacity, world demand growth, and world supply growth. These data have been great leading indicators of longer-term (2-3 year) trends in oil price.


Current Oil Supply-Demand Balance

The supply-demand balance changed significantly in the last two years. As you are probably aware, the U.S. oil production surged, driven by the fracking technology and by advances in shale extraction, making the U.S. the largest producer in the world this year. At the same time, demand growth remained low, around 1.3 mbd per year, due to slower global economic growth, and to gradual but steady transitioning to environmentally-friendly energy sources. In its 2013 Medium-Term Oil Market Report, the IEA went as far as to warn of a “supply shock:”

The supply shock created by a surge in North American oil production will be as transformational to the market over the next five years as the rise of Chinese demand has been over the last 15.

What is this chart telling us now? In this year’s Mid-Term Oil Market Report, the IEA shows spare capacity to be 5 bm/d this year, the highest since its 2009 spike, and projected to exceed that peak in 2016. Supply growth exceeds demand growth this year, which is to continue through 2017. So, the “supply surge” that the IEA warned about, is well under way.

Investment Implications

Based on these data, the drop in oil price below $70 is not at all surprising – in fact, it’s surprising that it didn’t happen sooner. The IEA’s medium-term supply-demand balance data are telling us that this is likely the beginning of a new trend of declining oil prices, not just a short-term price move. Accordingly, we would not recommend having much exposure to crude oil as a commodity, whether in the form of futures or ETFs.

How will the Energy sector earnings fare in this environment? Oil producer earnings are levered to crude oil price. If the price continues on a downtrend as the mid-term supply-demand balance suggests, it will be a tough environment for oil Exploration & Production (E&P) companies, especially for smaller, weaker players. This trend is critical for tactical investors/ tactical investment managers who actively manage their sector exposures.

Model Capital Management LLC is a tactical investment manager. Please visit the following web pages for more information on Model Capital’s approach to tactical investment management and our tactical asset allocation models/strategies.

Contact us to learn how we help RIA and other asset managers protect their clients from this new downtrend.

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