Non-fundamental factors drag crude oil prices

The precipitous fall in crude oil prices has spawned a whole lot of discussion on the causes of the price action and the desirability or otherwise of low prices in the long-term interest of the industry as well as the consumers. Current rates hover slightly above $60 a barrel, down from around $85 a barrel two months ago and $95/barrel a year ago.

Most analysts attribute the price collapse to a combination of factors on the demand and supply side. They assert that market fundamentals have undergone a change — rising supplies and weak demand growth. Expanding shale oil production in the US together with reluctance of most OPEC members and non-OPEC producers to cut production is cited as a reason for robust supplies.

The relationship between economic growth and energy demand is well recognised. Lingering macroeconomic concerns in the Euro Zone and in Japan as well as slowdown in China’s industrial activity are mentioned as factors leading to decelerating demand growth. On the face of it, these reasons are valid.

However, a closer look is warranted which may take the story to a different level. That demand-supply fundamentals have impacted crude prices is only a part of a bigger story and hardly helps explain the current price situation. If anything, reasons for the price fall are non-fundamental in nature covering geo-political developments, monetary policy, currency movements and speculation.

First of all, we have to look at why prices rallied in the last 2-3 years and went well past $110 a barrel. Between 2011 and 2013, global commodity markets were driven essentially by excess liquidity and a weak dollar. Quantitative easing by the US Fed meant availability of ‘easy money’ at nearly no cost for an extended period of time. Slowdown in the US economic activity including high unemployment rates pushed the value of dollar lower. At some stage, an euro could buy $1.38. A weak dollar props commodity prices up.

As for crude, geopolitical instabilities exacerbated the situation in different parts of the world and raised apprehensions of supply shock.

So, a combination of easy money, weak dollar and geopolitical tensions created an ideal situation for speculative capital to rush in. In a commodity market with fairly balanced demands-supply fundamentals, flow of speculative capital exerts an exaggerated impact on prices. By the market’s very nature, the price action is disproportionate to the flow of funds.

These factors have played out differently over the last six months or so. Geopolitical tensions have eased palpably, notwithstanding the as yet unresolved conflict between Russia and Ukraine. The ‘risk premium’ that crude buyers used to pay is no longer the norm.

After completion of the process of ‘tapering’ by the Fed and normalisation of US monetary policy, liquidity is not as easy as before. If anything, a potential hike in interest rate sometime next year makes the dollar dearer.

With the US jobless claims falling closer to the policymakers’ comfort zone and economic activity picking up, the dollar has been gaining strength steadily and solidly; and now stands at 1.24 to a euro.

These developments have resulted in a liquidation of commodity investment. In a falling market, less-committed investors exit first.

Again, in a falling market, the long-only funds usually hasten to exit as the case for price appreciation is weak. The cure for low prices is low prices.

Global economy is sure to benefit from current price levels although they will cause a shift in the external balances of some countries.

China and India are expected to benefit from falling crude prices as both are large importers and consumers. Oil is known as universal intermediate and low price of oil will help boost economic activity and contain inflation.