Adam Czyzewski

Last year, we outlined our expectations as to crude oil prices and margins over the coming two years. We anticipated substantial daily fluctuations as part of shorter or longer cycles, painting a statistical picture of the search for the marginal cost of production, as yet undetermined, providing a new frame of reference for oil prices. According to our forecast at that time, oil prices would continue to fluctuate at least until the end of 2016. We also thought oil prices would be highly sensitive to events altering market expectations. The situation on the oil market in Q1 2016 was indeed consistent with that climate of prevalent uncertainty.

 

The average price of crude in Q1 2016 was USD 9.9/bbl (23%) lower than in the preceding quarter and USD 20/bbl (37%) lower than the year before. In early January, oil prices continued the previous quarter’s downward trend, driven by worrying economic signals from China presaging a decline in demand. On January 20th, Brent’s daily price fell below USD 26/bbl. This happened two days after the International Atomic Energy Agency confirmed that Iran had satisfied the conditions of the deal to suspend its nuclear programme, which prompted immediate lifting of some of the sanctions imposed on it by the European Union and the US, opening the way to Iran’s oil exports. Iran’s unexpectedly quick return to the market, only partially priced in, should have caused a further decline in oil prices or at least checked their growth. However, something else happened. From January 20th, the price of oil climbed steadily, having grown 49% by March 31st (USD 38.71/bbl).

 

There were several reasons behind the crude price increase in Q1 2016, including, paradoxically, the economic weakness of China and non-OPEC crude oil exporters (Brazil, Mexico, Russia). Fearing a decline in demand outside the US, the Fed, and subsequently the market, made a downward revision of expectations regarding interest rate rises in the US. The change of the interest rate disparity led to an adjustment of foreign exchange rates and depreciation of the US dollar, which made investing in crude in other currencies more attractive. Yet another factor, whose impact on expectations was stronger than on the oil market’s fundamentals, was a (failed) attempt by Russia, Saudi Arabia, Qatar and Venezuela to reach an agreement to freeze oil output at January 2016 levels. However, in my opinion, the price spike was most likely spurred by an anticipated production decline in the US in the first half of 2016, estimated at 600–800 thousand barrels a day relative to the end of 2015.

 

Globally, onshore tight oil production in the US is the most price-sensitive segment. The opposite holds true for OPEC countries, which make output decisions based on non-business considerations, such as state budget needs. However, the cartel is not homogeneous. Saudi Arabia has the ability to increase production at a moment’s notice, and at low marginal costs, but still maintains an excess capacity and stable output. The other OPEC countries and Russia produce as much oil as they are able to at any given time, irrespective of the price. The third group comprises non-OPEC countries other than the US and Russia, where the project life cycle takes an average of three to five years – the same as in OPEC countries. However, they make decisions to invest in upstream projects based on future oil prices expected in several years’ time. Production in those countries has slowed down, but is still growing. However, due to considerable oil price uncertainty, numerous projects have been postponed or downsized. Bearing in mind the length of the project life cycle, low oil prices should translate into lower oil supply there in several years’ time.

 

Considering our current understanding of how production adjusts to low oil prices in different supply segments, we still expect the oversupply to be absorbed in Q4 2016. Consequently, we anticipate an increase in crude prices, which will be offset as production picks up in the US in swift response to the higher prices. The effects of dropping numerous projects to produce conventional oil will be felt by the market in several years, which is when we expect a more substantial increase in prices.

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