The world is drowning in oil. Since June 2014 the price of oil has fallen 70% to near US$30 per barrel and the global market remains heavily oversupplied. In 2015 the world produced 96.3 million barrels per day of oil of which we only consumed 94.5 million barrels per day and the remainder were placed into storage. Oil storage is at record levels.

However this situation has occurred before. During the 1990s OPEC, the Organization of Petroleum Exporting Countries who produce around 40 percent of global supply, were forced to maintain high levels of production to defend market share and oil slipped to less than US$10 per barrel. On this occasion Venezuela had a significant growth spurt in production while an economic slowdown in South East Asia reduced demand. OPEC managed to hold production through the 1990s, and eventually the oil price recovered to almost $140 per barrel at its peak in 2008. If the parallels hold, we could be in for a wild ride.

The past 18 months have seen OPEC again maintain production at or near capacity to defend market share. New production has come in the form US shale producers while China is experiencing an economic slowdown. The supply situation has also been compounded by Iran, which is about to resupply global markets after the removal of US and EU trade sanctions following a deal on the country’s nuclear capability. Iran will be the third largest producer within OPEC with expected production of 3.6 million barrels per day.

The resilience of the US shale producers has surprised despite OPEC’s attempts to drive them out of business. Since the middle of 2015 US shale oil producers have only reduced production by 0.4 million barrels per day and are still producing 9.1 million barrels per day. This is because the oil price is not yet below the absolute minimum price needed to cover cash operating costs to keep existing wells producing. The vast majority of oil production has cash operating costs below US$20 per barrel.[1] In addition some current production will have been sold forward by oil companies at higher prices to protect revenues. So the global supply taps have been kept open despite the freefall in price.

Despite the equity market volatility, particularly in January this year, there have been some winners from the downturn in oil. Low oil prices act as an effective tax cut, allowing consumers to spend more and business to have lower input costs. Both of these factors are positive for economic growth. Local companies where oil is a significant input cost include Air New Zealand and Refining NZ.

Looking forward, oil companies in the US are desperately in need of price stability to know where they stand and allow them to make decisions about their future. However, OPEC is incentivised create uncertainty and price volatility to discourage further investment. We expect the oil price to remain low until a material supply cut occurs and expect price volatility to continue. The global oil market is again in standoff and the fundamentals remain weak.

Sam Trethewey

Senior Analyst

[1] Citi Bank Research

Disclaimer: This is intended to provide general information only. It does not take into account your investment needs or personal circumstances and so is not intended to be viewed as investment or financial advice. Should you require financial advice you should always speak to an Authorised Financial Adviser.