Oil prices have fallen again, and a 'negative feedback loop' will push them even lower

Advertisement

This week's tumble in oil prices might not be the end of it.

Advertisement

"While significant uncertainty remains around what long-term price levels will ultimately generate a new set of equilibria to create stability in both the macroeconomic and micro commodity markets, we do have confidence that they are likely lower than current long dated price levels," Goldman Sachs' Jeff Currie wrote in a note to clients on Wednesday.

Currie added that with credit remaining easily accessible for oil drillers and prices stabilized, producers are still pumping oil into an already oversupplied market.

And so to Currie, the more than 50% decline we saw in oil prices last year still hasn't balanced the market.

"Not only did $60/bbl oil, strong high yield and equity energy markets create an increase in US drilling last week," Currie wrote, "But the market structure of the New Oil Order has generated the incentives for low cost producers such as core-OPEC and Russia to ramp up current and future production."

Advertisement

To start the week, West Texas Intermediate crude oil fell as much as 7% and at one point on Tuesday was down 9% in less than 48 hours.

"Acknowledging volatility in the data, the trend in low-cost production is clearly up. This is all against a backdrop of already oversupplied markets," the firm writes.

And so for Goldman, prices fell because of an oversupplied market, a problem that isn't likely to be fixed anytime soon.

Goldman says production isn't going anywhere until the full effects of what the firm calls a "negative feedback loop" that plays out not just across the oil and commodities market, but the global economy, are felt.

Here's Goldman:

Advertisement

The negative feedback loop is significant. The deflationary impulse created by lower commodity prices reinforces a stronger US dollar, as witnessed by recent moves in FX markets that resulted in weaker commodity currencies. This decreases the cost of producing commodities in these countries through lower wage costs that are priced in the weaker local currencies. Further, this deflationary impulse reinforces a stronger US economy and higher rates. The higher rates in turn raise the cost of funding for emerging markets, which reinforces the need for emerging markets such as China to deleverage and deal with significant macro imbalances developed over the past decade. This ultimately reduces the demand for commodities, particularly those that are tied to investment such as copper and iron ore.

And so, somewhat counterintuitively, we are going to see lower oil prices until things get worse in the global economy - but better in the US economy, warranting higher interest rates - and oil producers really feel the impact of a material decrease in demand and tighter financial conditions.

NOW WATCH: 6 scientifically proven features men find attractive in women