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The Truth About the “Oil Bear Market”

May was a rough month for oil prices, no doubt.

West Texas Intermediate (WTI) crude tumbled 18%, its biggest monthly drop in more than three years.

Critics were quick to point out that at about $86 a barrel, oil is now down 20% from its February peak of $109 – which was reached amid the most contentious point of the dust-up with Iran.

Technically, that puts oil prices in a bear market.

Still, it’s not time to panic. Nor has oil peaked. It just means the market is adjusting a bit after a serious bull run.

Remember, oil prices fell as low as $30 a barrel in early 2009, but here we sit, watching analysts panic over crude slumping to $87.

That’s not to say that some concern isn’t justified: Europe is a mess. Oil supplies in the United States are brimming. And the dollar is strengthening.

Those are some very significant short-term hurdles to overcome. And if the situation continues to deteriorate, we may see another oil bear market begin in earnest.

But the reality is that the long-term outlook for oil prices is as radiant as the short-term outlook is bleak.

If you still need convincing, just take a look at oil demand, which has been surprisingly resilient.

A Global Game

The International Energy Agency (IEA) actually raised its outlook for oil demand growth last month, even as it acknowledged the downside risks.

The group said that demand for oil in 2012 would increase by 0.8 million barrels per day (bpd) to 90 million bpd, with consumption in emerging countries “more than offsetting” declining demand in developed countries.

Oil consumption in Europe “is in a dire state, matching the region’s general state of economic malaise,” but declining trends in North America seemed to be abating, the IEA said. The agency also noted that demand continues to grow in China – despite talk of a slowdown.

China’s apparent oil demand in April edged up 0.3% year-over-year to an average 9.36 million barrels per day, according to a Platts analysis of recent Chinese government data. And in March, the country’s oil imports reached their third-highest level on record.

OPEC revised its 2012 world oil demand outlook upward last month, as well. The 12-country cartel forecast 2012 demand of 88.67 million bpd, up 900,000 bpd from 2011.

For decades, the United States was the only market that mattered when it came to energy demand, but that’s changed.

Something else has changed, too.

Crude Shifts

Oil is more difficult – and costly – to extract than it’s ever been.

That’s because most of the world’s oil production has traditionally come from the desert sands of the Middle East. But tomorrow’s oil will come from deep-sea deposits, which are often buried under thick layers of sand and salt or shale.

It takes oil prices upwards of $80 and $90 a barrel to make these kinds of projects profitable for oil companies. In fact, energy consultancy, JBC, estimates that the costs of exploring and producing oil from the newest and most expensive wells now costs more than $100 a barrel. Compare that to $50 to $70 a barrel before the financial crisis and $20 a barrel a decade ago.

That alone would be enough to keep oil prices high. But there’s more.

Like oil companies, the largest oil-producing nations need high prices to balance their budgets.

Countries in the Gulf Cooperation Council (GCC) rely on oil exports for 80% to 90% of their budgets. And as soon as it became apparent that historically high oil prices were the new norm, these countries increased spending. Combined budgets of GCC nations rose 19.3% to reach $359.1 billion in 2012, compared with actual spending of $301.1 billion in 2010.

For example, the United Arab Emirates (UAE) needs oil prices of at least $84 a barrel to balance its budget, according to the International Monetary Fund (IMF). And Bahrain requires prices of $119 a barrel to break even.

Of course, OPEC, led by Saudi Arabia, has been pushing output to its capacity for the last year in an effort to bring down oil prices. In fact, OPEC output in May hit its highest since 2008.

That simply won’t be the case if oil prices continue to fall. If prices slide below $80 a barrel the cartel will curb production. Once that happens we’ll begin working through the excess supply that’s swamped the market, and oil prices will bounce back once again.

So, yes, we may have entered an “oil bear market.” And yes, we may have to sit through further declines.

Truthfully, if growth in the United States and China continues to weaken, and if Greece leaves the European Union and it disintegrates, we could be in for quite a shock.

But on the other hand, if Europe gets its house in order – and growth in the United States and China levels off or edges up, then oil prices could return to triple digits by the end of year.

There’s simply no telling how bad it will get in the short term. The only certainty is that the long-term outlook for oil is decidedly bullish.

So keep your eye out for buying opportunities.

Cheers,

Jason Simpkins

Jason Simpkins

, Energy Editor

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