Falling oil prices continue to be the big story for the third straight week. Saudi Arabia reiterated that it sees no reason to cut production, even at $60 per barrel of oil. Iran said oil could fall to $40 a barrel if OPEC doesn’t start cooperating, then went on to indirectly accuse Saudi Arabia and their Gulf state allies of “treachery” for opposing production cuts amid falling demand. This week OPEC said it expects demand in 2015 will fall to about 29 million barrels per day, below current production levels of around 30 million. Iraq also said that price discounts to Asian buyers are not part of a price war, but along with Saudi Arabia and Kuwait, are offering their largest discounts in years.
The split in OPEC is between nations who desperately need high oil prices and nations who wish to defend their market share. The Saudis and other low cost producing Gulf states are unwilling to give up market share in order to raise prices, especially now that non-OPEC countries such as Russia and the United States are competitive threats. A lot of ink has been spilled arguing that Saudi Arabia is trying to break the U.S. shale producers with low prices. The Saudis may be happier to see their geopolitical enemy Iran in pain.
At the end of the day though, simple supply and demand is the most rational explanation. Low prices will be the new normal until production begins to fall, whether it be producers being priced out or OPEC relenting and cutting supply. We are getting very close to that point, if we haven’t already reached it.
The impact of low prices is starting to hurt the debt of shale producers in the United States. Thanks to the Federal Reserve’s ultra-low interest rates, many shale producers financed their capital investment with high-yield debt instead of low risk (from the viewpoint of the company) equity. With prices falling, companies are starting to run into trouble and some bond prices are down 40 percent since September.
The pain felt by producers has significantly benefited the consumer. Retail sales climbed a robust 0.7 percent in November, the largest increase since April. Sales of cars and trucks climbed in November, and one of the fastest growing segments is SUVs and pick-up trucks. The Financial Times reported sales of the Ford Navigator SUV climbed 92 percent over last year in November, while sales of the smaller Ford Fusion slumped 11 percent.
A growing economy is putting a dent in the federal budget deficit, which fell to $57 billion in November. The number was exceptionally low due to some spending into October, but the deficit is trending down this year. Two months into fiscal year 2015, the deficit is running nearly 7 percent below last year’s levels.
Even though economic news was good this week, stock indexes struggled due to large losses in the energy sector. In late trading on Friday, the oil sector, as measured by SPDR Energy (XLE), was down 7 percent on the week versus the 2.6 percent drop in the S&P 500 Index. Materials and industrials also weighed on the index.