What’s Driving Oil Market Volatility?

Why recent oil market demand and supply shocks are essentially unprecedented.

    Frederick G. Fromm, CFAVice President, Research Analyst, Portfolio Manager,Franklin Equity Group®

    At Friday’s OPEC+ meeting, Russia balked at supply cuts to offset the reduced demand we see from the spread of COVID-19.1 In response, over the weekend, Saudi Arabia dropped its export prices across the board, essentially starting a price war in the global oil markets. The idea seems to be to force Russia to come back to the bargaining table and agree to supply cuts.

    We believe the combination of both a demand shock (from the coronavirus outbreak) and a supply shock (from the price reductions) is essentially unprecedented, with no equivalent in the last 30 years that we can point to.

    Outlook

    The oil prices we are seeing currently are uneconomical for almost all market participants, in our opinion. While higher-cost producers like US shale clearly cannot generate profits at these levels, we believe even cheaper producers like Russia are likely to see challenges in this price environment. Saudi Arabia, while having very low production costs, also has domestic spending needs that likely require oil prices to be higher in the long term as well.

    Despite this, we believe there is continued room for prices to remain depressed in the short term, or even for the rest of 2020. Oil prices quite often under- or over-shoot price levels indicated by market fundamentals and may take time to settle back to normalized levels.

    Longer term, energy markets tend to be self-correcting with low prices leading to supply reductions that balance the market, and we believe we are likely to see significant supply destruction at current prices as drilling activity is either deferred or halted, particularly among smaller producers and those with poor balance sheets. While this could be healthy for oil markets longer term, it will be painful in the short term and will impact multiple industries both within and outside of the energy sector.

    We continue to have confidence in higher-quality producers and integrated oil firms. These are likely not just to endure through a period of lower prices, similar to what we saw in late 2015 and early 2016, but are also likely to be able to position their businesses well for the inevitable recovery in the markets. We do believe this process will take some time, however, as the market digests the impacts of the multiple factors driving prices down.

    ENDNOTES

    1. OPEC+ is an alliance of oil producers, including members and non-members of the Organization of the Petroleum Exporting Countries.