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Beware Goldman Sachs Oil Price Prophecy

Written By Geoffrey Pike

Posted June 19, 2016

goldmanoilOil prices have recovered somewhat from the lows we saw in 2015 and early 2016. Still, the price is down by more than half as compared to its high of a couple of years ago. The price of crude oil currently sits just below $50 per barrel as of this writing.

The oil bubble, and its subsequent bust, is one of the few examples we have seen of a bubble/ bust scenario since 2008/ 2009. The Fed has pumped in a lot of money since 2008, and interest rates have remained near historic lows.

It looked as though stocks were starting a bust phase back in January, but they have since recovered. At this time, oil still stands as the biggest asset class to have had a bursting bubble since the recession of 2008/ 2009.

There are certainly many contributing factors other than monetary policy. The shale oil boom in the U.S. has helped boost supply.

Meanwhile, the OPEC members, led by Saudi Arabia, have not been willing to cut back on supply.

While many have speculated that the Saudis were trying to hurt Russia and shale oil production in the U.S. with its move to not curtail production, it makes economic sense that the Saudis would keep running at high capacity. When you cut your own supply, you also cut your revenue, sometimes even with higher prices.

This is why it never made much sense when looking at the OPEC meetings where they decided whether or not to cut or increase production of oil. They can cut production, but others don’t have to do the same.

It helps in today’s world that OPEC controls a dwindling share of the oil market. It doesn’t make for a very good cartel when there is a lot of competition around the world for a fungible good.

So with global oil production still running high, it is hard to see how prices are going to spike back up to where they once were. Oil going over $100 per barrel seems only possible right now with some massive monetary inflation by the central bank.

A Way to Higher Prices

Analysts from none other than Goldman Sachs recently said that the only way for us to see higher oil prices is through unplanned outages and disruptions in the oil supply.

While I don’t always put a lot of faith into Goldman Sachs, sometimes the analysis can be telling. And in this case, the analysts are probably on to something.

Oil prices already were around $30 per barrel earlier in the year. If producers didn’t go bankrupt from $30 oil, then they are not going bankrupt with $50 oil. While shale oil production was hurt severely from the lower price, some continued on, even if they were producing losses. Once the initial price is paid to extract shale oil (or anything else), then it can still make economic sense to operate at a loss if you can sell the oil above the variable costs.

If a store buys a bunch of inventory and finds it cannot sell the inventory for a profit, the store doesn’t just throw the inventory in the garbage. It will still sell the inventory for a loss. The sales that do go through will help to minimize the losses.

The Goldman Sachs analysts are saying that we will have to see turmoil in the form of supply disruptions if we expect to see higher prices. The market is not going to naturally move prices higher without these disruptions.

And there are disruptions out there. Violence in Nigeria, which has never been a very stable region, has impacted oil production.

In Venezuela, there have also been declines in oil production. This is mostly just a political issue as well. The extreme socialism has brought so much havoc that even the country’s number one natural resource is being impacted. This is what happens when the government nationalizes virtually everything.

Many people are not aware that Venezuela is actually the number one country in terms of oil reserves.

Of course, we know that geo-political events often move oil prices. Oil prices jumped after the Iraq War. Just the increased possibilities of disruptions in production are enough to move prices higher.

While Goldman Sachs is indicating that unplanned disruptions are the major key going forward in determining oil prices, it would be unwise to just look at the supply side of the equation. There is also a demand side.

If we hit a major slowdown in the economy, this will reduce demand for oil. And with the global economy so tightly linked now, imagine major economic downturns in China, Japan, Western Europe, and the U.S. all at one time. That would likely send oil prices plummeting.

On the other hand, as mentioned earlier, central bank policy does play a big role too. If the Fed were to start pumping in massive new amounts of money, oil investors could once again benefit from a Fed-induced asset boom.

There are a lot of variables when talking about oil prices. Supply seems to be the biggest factor right now, but that can change quickly.