Brent crude prices have crashed below $40 a barrel for the first time since the depths of the global financial crisis as Opec floods the market to drive out rivals, with a parallel drama unfolding across the gamut of industrial metals.

The Bloomberg commodity index has fallen to within a whisker of lows last seen in 1998 and has now dropped by two-thirds from its peak, wiping out the entire gains of the resource supercycle. What China giveth, China taketh away.

While plummeting commodity prices can be a warning sign that the world economy is heading into recession, the latest sell-off has a different character.

The slump is chiefly due to excess production, and amounts to a “positive supply shock” that should boost global recovery. Bank of America said oil demand has risen by 1.8m barrels a day (b/d) over the past year, the second strongest in a decade.

“The oil market is driven by fear,” said Ole Hansen, from Saxo Bank. The spectacle of a neutered Opec unable to act in a clear crisis – or even issue a coherent statement – has rattled investors.

“We have a ‘dump and pump’ war between Saudi Arabia and Iran. It’s possible the Saudis will try to match the Iranians with an extra 500,000 b/d in an exhaustion game. Anything could happen,” he said.

“US inventories are already at record highs, yet we are going into a seasonal period when they normally rise further."

David Fuller's view

Here is a PDF of AE-P's column.

Commodity bear markets are usually brutal events, similar to those military drills when a couple of platoons are in a mud pit contest, trying to throw each other out until the last man standing wins.

In this oil pit contest started by the Saudis, they aim to knock out or at least weaken enough of the competition, not least US shale drillers, so that they can force another OPEC-led cartel which limits supplies.  

It will sort of work, at least for a while, but OPEC is less influential today because technological innovation has made it easier for more countries and companies to both discover and produce oil more cheaply.  Additionally, oil’s dominance is eroding due to the development of other forms of energy, from natural gas to renewables and nuclear power. 

Nevertheless, crude oil remains a hugely important commodity which is now in the climactic phase of its bear market.  As Brent crude falls further in the short to medium term, this will reduce output but more importantly, increase pressure on a number of producers to accept a new OPEC-style agreement which limits production.  Reducing supply is the key but this will also occur at a time when demand is rising in response to low prices.

While production cuts are essential before a significant recovery occurs, it will not get anywhere near the highs seen between February 2011 and June 2014.  Russia and most other non OPEC oil exporters are unlikely to reduce supplies because they have devalued, unlike the Saudis, although their peg to the US Dollar is less secure today.  US shale producers are likely to increase production above $60 a barrel.  Other countries have the capability to produce shale oil and gas, including the UK.  The development of increasingly efficient renewables led by solar continues.  New nuclear plants are under development.   

Permanently lower energy costs than we saw only eighteen months ago will contribute to stronger global GDP growth in the years ahead.