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Why is the oil price falling?

Liz Dhillon takes a look at the recent drop

  • Oil is down 30% from its recent high, partly because of concerns over global growth but also rising US inventories and a lower than expected fall in Iranian production

  • The short-term direction for oil is likely dependent on OPEC’s next meeting on 6 December

  • But in the longer term, the oil price is probably heading higher due to a lack of investment in new oil fields and production capacity

Oil prices have fallen significantly over the past two months, with Brent crude down by around 30% from its recent high. A range of concerns have been raised, including fears around a US-China trade war, slowing global growth, lower demand from the Middle East and China, and lower than expected Iranian production.

Despite this, the drop in the oil price may prove to be a relatively short-term phenomenon. Iranian production has been higher because sanctions have not been as tight as they were expected to be. Iran has been allowed to keep on selling its oil to a range of countries because Trump has issued special waivers allowing the import of Iranian oil. This may have temporarily driven the oil price higher than it should have been, but it doesn’t signal a worse outlook for the commodity now.

Falling prices also reflect the US-centric nature of the non-physical (i.e. speculative) market in oil. Traders tend to closely follow US oil inventories, which have been climbing in recent months as transport bottlenecks have forced production into storage. While higher pipeline capacity should come online next year, transportation difficulties should mean an elevated amount of oil in storage for the next six to nine months.

The short-term picture for oil

A key factor for the short-term direction of the oil price is the outcome of the next OPEC meeting, due to be held on 6 December. Trump has piled pressure on Saudi Arabia (the leading producer in OPEC) to maintain high production, apparently demanding lower oil prices in return for not reacting too aggressively to the murder of the Saudi journalist Jamal Khashoggi.

While this puts the Saudis in an awkward position, they do have the ability to fudge the issue. OPEC is currently producing more oil than it’s officially supposed to. The cartel originally adopted production constraints three years ago in response to oil prices falling to below $30 a barrel.

This ‘unofficial’ extra production gives OPEC and the Saudis room for manoeuvre. They can reduce production, but still claim that they haven’t agreed to a production cut. It’s a political gesture, but they’re hoping the rhetoric will be enough for Trump. Russia, which has worked with OPEC over the past two years, is less worried about what the US administration wants. 

The long-term outlook for the oil price

Beyond the next few months to a year, the long-term picture for the oil price looks positive. Oil companies constantly need to invest in new production in order to replace what they’ve taken out of the ground, and while they’ve invested enough for the next one to two years, this is not the case for the longer term.

There’s a significant time lag between deciding to invest in new production and actually getting oil out of the ground, so if oil companies are going to start replacing their reserves for beyond 2020, they need to start investing now. The risk is that the current decline in prices makes them less keen to do so, with this potentially forcing the oil price higher in the long term. Barring a global recession or another significant rise in US production, the trend for oil is probably up.

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