The key lesson to learn from sliding oil prices

published 25 November 2014

141125-opec-b2 — Opec has very little control over oil prices

Imagine chairing a meeting involving bigwigs from some of the world's premier dictatorships and tinpot despotisms.

Imagine that half of them basically hate the other half. The only thing that unites them is their joint monopoly over the production of a very valuable substance, on which most of them are utterly dependent for revenues. And this monopoly is now under threat from one of their biggest customers.

Imagine trying to get them all to agree on what to do.

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It sounds like the management meeting from hell.

Welcome to the world of oil cartel Opec. They're having just such a meeting this week.

It promises to be eventful

Opec can't control oil prices

So far, Opec's reaction has been to do nothing. This week, they're having a meeting in Vienna. Around about 3pm on Thursday, there'll be a press conference where they tell us what they're planning to do.

You're likely to read a lot of analysis about it this week. But here's what it boils down to: unless you're planning to trade the oil price in the short term (in which case you should be focusing on charts and sentiment rather than worrying about the fundamentals') it doesn't really matter what Opec does.

Some countries need higher oil prices than others. They've based their public spending on prices at a certain level. Generally speaking, the more tinpot the nation, the higher the crude oil price it needs (so Venezuela needs $100 a barrel, for example).

If you want higher prices, you need to cut production. Trouble is, the same tinpot countries generally need the cash flow more than the others too. So they can't really cut production without reducing their income immediately.

So they'd rather that Saudi Arabia the big operator cut production, while they get to keep pumping. But Saudi Arabia isn't keen to do that and hand over market share to its rivals.

It all makes for a fairly ineffective cartel. Opec can co-operate when oil prices are high even when the countries involved are pumping flat out. But it gets a lot trickier when prices start to fall and budgets get squeezed.

So while an agreement to cut production might give the oil price a brief lift, there's no reason to expect that to last. As David Fuller points on FullerTreaceymoney.com, "even if [Opec] agreed to lower production, that discipline has never held for long in the past."

In any case, the cartel's grip on the oil market is far looser than it was in the past. The rise in US oil production means that Opec now controls around a third of the global oil market, rather than around a half as it did in the 1990s.

The most valuable lesson to learn from the oil-price plunge

The funniest thing about all this is how the consensus has switched so rapidly. Here's a quote from a good piece by Andrew Critchlow in The Telegraph, for example: "Whatever action Opec agrees to take next week to halt the sharp decline in the value of crude, experts agree that one thing is clear: the world is entering into an era of lower oil prices that the group is almost powerless to change."

I find this paragraph hilarious. It's nothing to do with Mr Critchlow's writing. It's the conviction of the experts'.

This era of lower oil prices' wasn't on the experts' radar just a few months ago. For example, in July, both the World Bank and the International Monetary Fund reckoned oil would average just over $100 a barrel this year.

And it's not just multilateral institutions'. Until the end of October, Barclays reckoned that the oil price this quarter would average $106 a barrel. It's still forecasting $93.

About the only thing the experts' agreed on six months ago was that oil prices would stay roughly the same as they had been over the previous three years somewhere around the $100 mark.

Yet, now that the $100 mark has been breached, we're suddenly in a new era'?

What the sudden change shows more than anything else is how worthless expert' forecasts are. The majority of this analysis is nothing more complicated than taking what happened last year and adding or subtracting a little bit. In effect, the analyst decides on the price, then rationalises that decision with a story that sounds good.

You can say that for just about any market. Which is why it's important to do your own thinking because the experts' aren't doing it for you.

Where to next for oil prices?

But in the longer run, it seems likely that oil will be less of a burden on the global economy than it has been. Why? Prices have to stay at roughly a level that will enable producers to get it out of the ground at a viable price.

But the high and rising prices of the last decade have encouraged investment in new technologies and even substitutes. Those are now sufficiently far advanced that their backers have to find ways to make them work.

A lower oil price might scupper some fracking efforts. But it will also persuade others to invest even more money in finding ways to make fracking more efficient in finding ways to make it work, whatever happens.

So we've gone from a phase of under-investment and high demand that left us scrabbling to get hold of more oil, to a phase of high investment and relatively weaker demand that means we've got enough.

In short, on a big picture' outlook, I think we're moving into a world of falling or stable oil prices. That's a good news story for the vast majority of us. I talked about how to take advantage of it in a recent issue of MoneyWeek magazine.(If you're not already a subscriber, get your first four issues free here.)

By the way, if it's shorter-term ideas you're after, you can find great ideas on trading strategies, ETFs,or funds to buy for the year ahead at the eMoneyShow. You can tune in now, and the content is available on demand until 10 December. Register for free here.

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.