FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
May 15, 2018

1. A Brief History of Oil Prices in Recent Years

2. Oil Prices Surge to Highest Level Since 2014

3. Economic Implications of Sharply Higher Oil Prices

4. Oil is a Commodity Subject to Supply and Demand

A Brief History of Oil Prices in Recent Years

From mid-2011 to 2014, the price of West Texas Intermediate (WTI) light crude oil traded in a lofty range of $80-$110 per barrel. But in late 2014, oil prices began a dramatic plunge. Here’s a brief explanation.

Oil prices began to crash in 2014 because the Organization of Petroleum Exporting Countries (OPEC) oil cartel, led by Saudi Arabia, underestimated the production capacity of US shale oil producers.

The US was rapidly becoming one of the largest oil players in the world, and yet the rest of the world’s producers were blithely continuing on their merry way. They were confident that they could keep pumping out oil at around $100 a barrel, and it would have no effect on consumer or producer behavior.

Yet as always, economics forces people to find a way to cope. A combination of substitution effects with alternative sources of energy and rocketing US production created an oil glut, causing prices to plunge.

The oil glut was sustained by another OPEC miscalculation: The cartel assumed it could outlast the US shale industry. But while OPEC had low production costs, its members (especially Saudi Arabia) had huge bills to pay at home, including bribing their people to prevent the “Arab Spring” from spreading.

Shale producers, on the other hand, were able to run at a loss because of the steady flow of cheap credit thanks to the Fed. Rapidly improving technology brought production costs down significantly and enabled them to survive the oil price winter when WTI prices plunged to below $30 per barrel.

OPEC gave up first in its attempt to keep prices down. It teamed up with Russia to cut oil production significantly. And much to everyone’s surprise, a loose union of countries better known for stabbing each other in the back managed to stick to the plan.

Meanwhile, global growth picked up – recovering swiftly from a brief scare in 2015 – and as a result, oil supply and demand gradually came back into balance. Prices began to recover.

Global oil consumption is set to top 100 million barrels a day for the first time ever this year. Indeed, the International Energy Agency said recently that OPEC could pretty much declare “mission accomplished.” Today, there is no more oil glut, and that has helped drive prices to their current levels.

Oil Prices Surge to Highest Level Since 2014

US oil prices recently rose above $70 a barrel for the first time since 2014, the latest sign that solid economic growth and investor concern about the risk of Middle East conflict are once again boosting the global energy industry.

West Texas Intermediate light crude futures soared above $71 per barrel last week amid growing demand despite the sharp increase in prices – up from the low in the mid-$40s last summer.

The $70-a-barrel milestone represents a victory for Saudi Arabia, OPEC and Russia. Their commitment to reduced production managed to dry up a massive glut of oil more quickly than many on Wall Street expected.

The rebound is also a relief to US oil companies that endured an oil bust that sent crude prices below $30 in 2016. US refiners have been among the best-performing stocks this year, as demand for the fuel they churn out continues to expand.

But supply, demand and inventories are far from the only factors at work. Oil prices have risen nearly 14% in the past month as President Donald Trump indicated the US would likely withdraw from a 2015 agreement with Iran that eased international sanctions on Iran in exchange for curbs to its nuclear program.

President Trump made good on that promise last week and withdrew the US from the Iran nuclear agreement. He also reinstated severe economic sanctions on Iran that could curtail its oil output going forward – a move that sent crude oil prices sharply higher.

At the same time, Goldman Sachs reported that global oil demand surged to the highest level in seven years in the 1Q of 2018, despite the significant increase in prices.

Economic Implications of Sharply Higher Oil Prices

Higher energy prices pose negative consequences for the US and global economies and result in increased costs of production and thus the cost of goods sold. Likewise, higher energy costs take money out of consumers’ pockets that could be spent on other goods and services.

Rising crude prices will also put pressure on the margins at US transportation companies like airlines, railroads, trucking companies and delivery services, which will be paying more for fuel after years of cost savings. Automakers could also have cause for concern, as the SUVs and trucks that have driven US auto sales in recent years may become less appealing to consumers as prices at the pump edge toward $3 a gallon.

Factors outside of OPEC’s control have helped lift oil prices. For example, Venezuela’s output has been falling faster than most expected, as its political and economic crises worsen. Just about every day there’s some new story that’s not good for their production capacity.

Rising geopolitical risks, especially in the Middle East, have also contributed to rising oil prices recently. Rising tensions between Israel and Iran, including last week’s exchange of missiles, have kept upward pressure on energy prices. This could change, of course, for better or worse.

It remains to be seen how long OPEC will keep oil production restrained. Saudi Arabia is aiming to push global oil prices to at least $80 a barrel, senior officials said recently. But some other OPEC members are said to be considering production increases before long. If so, this could have a potentially negative effect on oil prices.

Meanwhile, in the US, shale producers have already pounced on higher prices, hiring workers and buying equipment. Output has climbed above 10 million barrels a day – its highest ever. And since a ban on most crude oil exports was lifted in 2015, shipments of US crude have flowed to Europe, Asia, and South America and gained a foothold in markets once dominated by Middle Eastern suppliers.

The question is, how bad are higher energy prices for the US and global economies? More and more analysts are arguing that higher oil prices are not necessarily as bad for the US economy as they used to be. I’m not sure I buy that argument.

The logic is, while US consumers have already started paying more at the pump, oil prices would have to climb to $80 to $100 a barrel before it would significantly crimp consumer demand, say some economists.  But the fact is, most households have a fixed budget and if energy prices rise, that leaves less to spend on other goods and services.

So, I would continue to argue that higher energy prices – whether oil is $70 a barrel or $100 – are a drag on the economy.

Conclusions: Oil is a Commodity Subject to Supply/Demand

Finally, let us not forget that oil is a commodity which is subject to the laws of supply and demand. With crude prices now above $70 per barrel, oil producers are increasing exploration and production. Already, production has increased to the point that the US is now exporting oil around the world, as noted above.

As prices have risen lately, the US drilling rig count has turned higher. According to oilfield services provider Baker Hughes, the active rig count increased for the fifth consecutive month in April to the highest level since March 2015.

This is what always happens when oil prices get profitable enough for oil producers. While it’s impossible to know exactly when prices reach the point that supply outpaces demand, it will happen at some point – and prices will fall.

We may not be there yet, but I wouldn’t advise loading up on oil stocks or energy ETFs at this point.

Webinar: ZEGA Buffered Index Growth Strategy (ZBIG)

On Tuesday, May 22^nd, at 3:00 Central Time we will be presenting a live webinar with Jay Pestrichelli, the Co-Founder and Managing Director of ZEGA Financial. Register today for this great opportunity to hear directly from Jay about their ZEGA Buffered Index Growth (ZBIG) Strategy. It is designed to provide upside exposure to the markets when they are going up, while also using a “buffered zone” to help protect you if the markets drop.

You really don’t want to miss the opportunity to hear from Jay about this strategy that you probably won’t find from your typical financial advisor – one that gives you the potential to participate in the market gains, while limiting your downside risks. You can even ask Jay your questions about ZBIG at the end of the presentation.

Even if you can’t make the live webinar, be sure to sign up. If you do, we’ll send you a recorded version of the webinar that you can watch at your convenience. You can also call us at 800-348-3601 if you want to learn more about ZBIG.

As always, keep in mind there are no guarantees with this or any other investments.

All the best,

Gary D. Halbert

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