The oil price has bottomed out – here’s why

The oil price has been crushed since last summer.

It’s gone from over $100 a barrel (both Brent and WTI, the main benchmarks) to as low as below $50.

Two main factors have driven this: a healthy supply of oil, and strong demand for US dollars.

But both those trends look at risk of reversing.

And that could mean a rebound for oil.

Trouble flares up in the Middle East (for a change)

Oil prices spiked higher yesterday, as Saudi Arabia launched air strikes on Yemen. The price of Brent went up to nearly $60 a barrel, while WTI (the US benchmark) rose to around $52.

As ever in the Middle East, the details are complicated (we’ll look into it in more detail in the next issue of MoneyWeek magazine). But keeping things simple, the Saudis and other Gulf Arab states are fighting Iran-backed rebels in Yemen, in an attempt to defend the Yemeni government.

As the FT describes it, it’s basically a Sunni-Shia cold war, with Shia Iran on one side, and the largely Sunni Arab nations on the other.

Now, Yemen doesn’t matter much to the oil price. As various pundits on CNBC point out, Yemen isn’t a big oil supplier, and the trouble isn’t directly disrupting trade routes – yet. “This could help move oil prices partly, but we don’t see that this will disrupt actual oil supply,” said one South Korean oil expert.

Trouble is, of course, that’s just the specifics of this particular conflict. As another commentator pointed out: “If a proxy war becomes a real war, the entire Middle East will be engulfed… even though I do not think that is likely.” Clearly that would be much more disruptive to the oil supply, not to mention bad news in general.

Now, as we always point out, there has pretty much never been a time when you couldn’t describe the Middle East as ‘tense’. Events that look like headline-grabbing disasters one day quickly turn into a grim form of ‘business as usual’ the next.

But when the market is as bearish on oil as it is just now, it doesn’t take much bad news to turn things around. For example, according to the FT, investors have the most short positions on record (in other words, they’re betting on falls) in WTI. That leaves them vulnerable to ‘a short squeeze’ – where a rebound in prices becomes self-reinforcing as burned bears are forced to close short positions.

The other reason for oil’s massive decline

Of course, none of this will stop the US from continuing to pump out oil. Stocks remain at record levels, and show little sign as yet of falling. But there’s another critical factor in the sliding oil price that may be less obvious – the strong US dollar.

As a rule of thumb, a strong US dollar isn’t going to be good news for most resource prices – simply because they’re priced in US dollars. And oil’s slide coincides quite neatly with the US dollar’s rapid surge in recent months.

But the dollar seems to have hit something of a wall this week. The Federal Reserve seemed rather hesitant this week on interest rates. Fed chief Janet Yellen is clearly in no hurry to raise rates unless she absolutely has to.

Meanwhile, economic data for the US was below par yesterday. Orders for durable goods – ‘big ticket’ items – fell unexpectedly in February, and the figures for January were revised down too. That gives Yellen more firepower to take it easy on rate rises.

In turn, that means the dollar could be in for a longer pullback. As the market gradually gets accustomed to the idea that rates may not rise until much later in the year – if at all – the strong dollar story gets harder to sell.

Overall, even if the oil price isn’t due to rocket higher, there seems a good chance that it’s seen the bottom for this particular crash. And the longer that prices remain low, the more likely it is that we’ll end up seeing supply shortages again at some point in the future – possibly more quickly than we expect.

We looked at prospects for oil in a recent MoneyWeek magazine cover story. If you’re not already a subscriber, you can get your first four issues free here.

• This article is taken from our free daily investment email, Money Morning. Sign up to Money Morning here.

Leave a Reply

Your email address will not be published. Required fields are marked *