John Lynch Chief Investment Strategist, LPL Financial
Last June, oil hit an interim low of about $42.50 and started to climb. By May 7, 2018, it had crossed $70 for the first time since 2014. President Trump announced the U.S. world be withdrawing from the Iran nuclear deal the next day. We view rising oil prices as largely a result of rebalancing supply and demand, and believe prices will stabilize as markets digest the recent news. The Organization of the Petroleum Exporting Countries (OPEC), its partners, and U.S. production growth should be able to compensate for reduced Iranian supply. Even if prices stabilize at current levels, it will be a modest hit for consumers, especially those at lower income levels, and it may temporarily push headline inflation higher; however, we believe the impact may be small compared to economic support from a strong job market and the new tax law.
OIL SWINGS NORMAL, BUT EXPECTING INCREASED BALANCE
Oil prices are naturally volatile, even more than equity markets, and recent experience has only reinforced the fact. In early 1999, oil sat near $11 per barrel, but by 2008 it had peaked at over $140 [Figure 1]. During the recession we saw oil fall to just over $30 before once again topping $110 as late as 2013.
Since then we have seen oil crash to the mid-$20s, but now it sits at over $70. Such swings are normal over time, but they can be punctuated by periods of relative balance. Oil, as a hard asset, is driven by the basic law of supply and demand, but given the capital-intensive nature of the industry and its sensitivity to geopolitics, price cannot always adjust quickly and therefore can be very sensitive to shocks, sentiment, and shifting imbalances. But, assuming no new disruptions, over time a new balance should take hold.
Oil’s volatility creates challenges for consumers, but also to businesses and even the producers. Over the last several years, oil markets have had to adjust to the growth of U.S. shale, changes in global demand, and the constant potential for supply disruptions. Under normal conditions, these fundamentals create a range where oil prices should approximately settle, and, given healthy global demand, we believe we are near that range right now. But when markets perceive even potential disruptions, there can be an impact on producer, consumer, and even speculator behavior as markets prepare for different potential outcomes.
IRAN IN FOCUS
Recent concern has focused on Iran and the U.S. withdrawal from the 2015 nuclear deal. Iran is the world’s fifth largest oil producer and the renewal of U.S. sanctions will certainly have some impact on supply from Iran. Even so, Iranian oil will continue to help meet some international demand if the Iran deal remains in place for some countries outside the U.S. Currently, China, Russia, France, Germany, and Iran itself all remain in the nuclear accord, making the impact of the U.S. withdrawal on Iranian crude exports uncertain. Analysts estimate that Iranian exports could fall by anywhere from 200,000 to 1 million barrels per day, a significant but likely manageable amount. Some of the lost supply, however, could be met by OPEC nations and partners outside of OPEC who had agreed to lower supply to help stabilize oil prices.