The Exchange

AN OIL MARKET INTERVIEW

with Mike Davis, Director of Oil Market Development at ICE

Insights into the oil sector and what it means for the global economy

Q: Could you talk about the history of oil prices and the drivers behind them?

A: Sure. We've seen crude oil prices influenced by any number of economic and geopolitical factors ranging from production or demand changes, unplanned interruptions in supply, economic growth and inventory surplus, just to name a few factors. If you look at a historical chart of oil prices, you’ll see several major price changes that were driven by these events at various points over the last few decades: the Iranian revolution of 1979, the Iraqi invasion of Kuwait in 1990, the global financial crisis in 2008. As shown in the chart below, oil prices eventually corrected each time the price reached a high or low point.

History of Crude Oil Prices - Brent

As far as the current crude oil market goes, what we’re seeing now is the result of more oil being produced than the world is consuming at present. When the price of oil began to fall initially, there was a clear demand increase; as oil became cheaper, we saw consumers driving more, some started buying less fuel-efficient cars, which reversed a trend away from more efficient vehicles. However, as oil-producing countries have maintained production at near maximum capacities and governments took a hands-off approach to pricing policies, we have started to see a shift in supply and demand. There's a maxim that says the cure for low prices is low prices, and that's what the market appears to be testing right now.

Q: Has market liquidity been adversely affected by the fall in the price of crude oil?

A: Overall liquidity in crude oil markets is strong when measured in terms of volume and open interest. For example, the Brent Crude Future averaged over 1 mm contracts traded a day in January 2016 with open interest over 2 mm contracts - just shy of its OI record.

There’s been a revival of interest in crude oil futures trading in the U.S. with the growth in the economy and greater volatility in the price of oil. The U.S. has completed the majority of its financial regulatory reform program; for example the implementation of the Dodd-Frank Wall Street Reform Act. It's possible this has supported U.S. retail investment interest in oil, leading to more activity in oil exchange-traded funds (ETFs) and in the futures trading against those ETFs.

ICE Brent Total Volume and OI

Q: How are supply and demand influencing the current market, and which is having the strongest influence?

A: The market is always influenced by a combination of supply and demand. However, overall the market at present is especially determined by supply. The U.S., Saudi Arabia, and Russia all continued producing large quantities of oil well into the price decline.1 Iranian oil production is another supply factor with up to 500k barrels per day expected to return to the market over the near-term, though that's expected to be gradual.2

Q: We’ve heard a lot about the revolution in U.S. oil production. How significant has that been and have oil markets changed dramatically as a result?

A: The U.S. production of light, tight oil, or shale, is significant.

What we’ve seen in the last five years is the fastest net growth in oil production we’re aware of in U.S. history. The U.S. went from producing approximately 5 million barrels to almost 10 million barrels a day.3

When thinking about the motivation to continue producing light, tight oil in such large quantities, you have to consider the change in U.S. export laws. The lifting of the U.S. crude export ban had many companies interested in overseas exports, but the economy isn’t quite ready to support that in excess.

Shale production at these levels was bearish for oil prices, partly because of the sheer rate of growth at which the oil was produced. Now that the low oil price fall has halted production, this growth rate is behind us.

Q: Will the consequences of the price fall be short-, medium- or long-term?

A: The quick answer is “yes” to all of the above. We’ve already seen the short-term results of a lower oil price as petrol / gas consumers start traveling more. Now we’re starting to see a slight deflationary environment in which market participants are evaluating the root cause behind the price decline. They’re wondering what this means for the global economic situation. China, in particular, is front and center. We’re seeing conversations around whether or not growth in the world’s number two economy is slowing and what that would mean for Chinese oil demand.

Q: Are there consequences for other markets outside of oil? What other markets are strongly related to oil prices?

A: The most obvious impacts are in the markets for natural gas, corporate bonds tied to the U.S. dollar, and U.S. and global equities. When it comes to natural gas, the assumption that natural gas would eventually replace some oil usage has reduced somewhat given the increased affordability of oil. When it comes to the U.S. markets, a large driver behind the country’s economic recovery and growth has been the energy sector. Now that the sector is slowing, the potential impact to global equity markets is still uncertain.

And, of course, the strength of the U.S. dollar is playing a key role. There’s a well-established negative correlation between the dollar and oil prices, which is coming into play in the current market. If you’re an oil producer – for example, Russia – and you’re paying for production costs with a currency like the Russian Ruble but getting paid for your product in dollars, there’s a big impact.

Q: Are there major impacts on crude oil benchmarks because of the change in price?

A: The current market has reaffirmed the importance of the core crude and refined oil benchmarks. In times of market volatility, market participants rely on highly liquid benchmark contracts to manage price risk.

With up to two thirds of the world’s oil priced off the Brent complex, the Brent Crude futures contract is a key hedging mechanism for oil market participants. Because Brent is seaborne, it’s the leading global benchmark for oil, so it’s natural to see trading activity in Brent strong right now; open interest from the end of 2014 to the end of 2015 is up 38%. We’re also seeing strong activity in Gasoil, because it hedges exposure to diesel. If you look at year-over-year open interest and volume in Gasoil for 2015, there’s been a 60% and 15% increase respectively.