5 Aug 16

Oil oversupply is pushing energy prices down again

Just a few months ago, it seemed oil prices had bottomed out. West Texas Intermediate, America’s benchmark crude oil, was again trading at over $50. Analysts predicted further recovery, with prices ranging from $70 to $80 per barrel. But the $50 hurdle proved too high, and West Texas Intermediate has since sunk under $40 again.

The downward pressure on oil prices emanates from the Middle East, and particularly from OPEC heavyweight Saudi Arabia.

Downward spiral
The Saudis seem caught in a downward spiral: lower oil prices have eaten into their revenue, which they are trying to compensate by increasing production. However, this pushes prices down even further – thus further reducing Saudi oil revenues. Earlier this week, it was announced that the Saudis are giving their Asian customers large discounts on Arab light sweet crude oil: instead of the going rate of $1.30 per barrel, they only have to pay $1.10. The discount is a sign of weakness, a desperate measure of the Saudis, hoping to prevent an even bigger budget deficit. Cutbacks to social services in the country have already been so severe that it is feared further belt-tightening could lead to widespread unrest.

$20 per barrel
Worried about current oversupply, some analysts fear crude oil prices could drop to $35 per barrel – with pessimists fearing a slide towards $20, unless measures are taken to restrict oil production. Weak demand in China and India is exacerbating the supply-side problem. Yet it is highly doubtful that Mohammed Sanusi Barkindo, the Nigerian who succeeded the Libyan Abdalla Salem El-Badri as secretary-general of OPEC, will be able to convince the member states to limit production. Barkindo’s candidacy was not uncontested, and the Saudis are likely to resist attempts to impose constraints.

Risk of deflation
So, what are the consequences for the global economy of this further drop in oil prices? Cheaper energy is of course good for manufacturing, also because it frees up funds for additional investments. But in the long run, low oil prices increase the risk of deflation. In such a scenario, falling prices will make it advantageous for companies and consumers to delay their purchases. That could result in an economic downturn serious enough to fully compensate the positive effect of lower oil prices.

Authored by: Steven Schoefs