January 11, 2016
Daily crude price data tell the story: in 2015 the prices yo-yoed. At the beginning of the year, Brent oil traded at 55 USD/bbl. In mid-May, the price went up to USD 66, to dip below USD 35 at the year end. It has not been that cheap since December 2008. But the world was entirely different back then.
- In 2008, there was panic on financial markets, and the world’s economy was sliding into recession. Global GDP shrank 1.6%, after many years of growth at the rate of 4.5%.
- For the first time since the oil crisis of the 80s, demand for oil and fuels fell, by 0.6%, following a period of strong growth at 1.9% annually in 2000−2007.
- The drop in oil demand was fuelled by a rapid rise in oil prices. In the 12 months to the day when Brent peaked at 144.23 USD/bbl (July 3rd), the price soared by 94%. The hike was driven by concerns about possible shortages, as OPEC production reserves were gradually falling, with no significant production increases in sight.
- OPEC truly controlled oil prices. At a meeting held in Oran, Algeria, on December 17th 2008, the cartel decided to cut production by 4.2m barrels a day (more than 14%) as of January 1st 2009. After that, oil prices began to climb.
Today the situation is completely different.
- Since the beginning of 2014, the oil market has suffered from oversupply, one of the reasons being the growing production in the US, which for quite a long time was masked by output cuts in the Middle East and North Africa.
- With the significant spare capacity in the US and the shortening of the investment cycle on oil fields (tight oil), OPEC lost (at least for some time) control over oil prices.
- Once the oil price anchor created by OPEC’s strategy was removed from the market, oil became a true commodity, and its price is now a function of complex interactions between physical oil markets (spot and futures) and financial markets.
- Decisions made from the perspective of financial markets have more impact on daily oil prices than developments on the physical markets, which only adds to the volatility of crude prices. In 2015, daily change in Brent price, measured by standard deviation, was nearly 8 USD/bbl, or 15% of the average price.
Predictability of daily oil prices is now comparable to that of short-term exchange rate movements for liquid currencies. It is so as oil price is one of central macroeconomic categories: while it has an impact on “everything”, starting from central banks’ decisions on interest rates and exchange rates, to revenues and expenditures of state budgets, and incomes and expenditures of businesses and households, it is at the same time driven by those factors.
After OPEC’s decision of November 2014 to defend its market share, oil price is now looking for support in the marginal cost of oil production, which remains unknown. In February 2014, I wrote that this process would continue until the glut is absorbed, that is for some two years. Before this happens, oil price may fluctuate freely within quite a wide band, between 20 and 80 USD/bbl. Then, it is going to rise, with the growth rate depending on the scale of production potential downsizing in 2015-2016. These expectations were elaborated on in June 2014, and described in our discussion of the outlook for oil prices until 2020. In my opinion, they are still warranted. Oil prices at the end of 2015 are on the low end, but still within the range I indicated above. The prices may plunge deeper, but only in the case of daily quotations, which are material to financial transactions. For wider price windows, which drive the performance of oil companies (average quarterly oil prices), we still expect sustained growth trends to emerge towards the end of 2016. The key considerations which we believe support our opinion that the oversupply will be absorbed at the end of 2016 are related to supply adjustments and demand growth:
- The OPEC meeting in December 2015 showed that no change in OPEC’s policy is to be expected any time soon, one reason being a conflict of interests between its members.
- The sustained low oil prices ultimately curbed the growth of oil supply from non-OPEC countries in 2015, with their production even expected to decline in 2016.
- At the same time, the low crude prices spurred demand for oil and liquid fuels. It expanded by some 1.3-1.5 mbd, i.e. almost three times faster than in 2014, and this despite the effect of decelerating demand from China.
- In 2016−2020, demand should grow at a similar rate of some 1.3-1.5 mbd.
Potential risks to this scenario, which we have not mentioned yet, result mainly from the possibility of an additional supply reaching the market in 2016−2017, although one cannot rule out certain factors that may tip the scales towards a faster price growth (such as ISIS).
- Part of the demand is attributable to large oil and fuel stocks, estimated at some 0.7 mbd and expected to reach 1 mbd by the end of 2016. A substantial portion (more than half) of these are strategic stocks, built at the time of low oil prices (China, other countries in Asia). The rest may find its way back to the market.
- Iran returning to the market with a higher-than-expected supply (When will the sanctions be lifted? How much oil can Iran produce in a short time? What will its market entry strategy look like?)
- Other countries returning to the market (Libya)
- The lion’s share of output cuts was in the US, where production can be resumed quickly, especially if the US export ban is lifted
Should these factors materialise, the effect would be, to a lesser extent, a longer period of searching for price equilibrium and, to a larger extent, a slower pace of price growth. This, however, does not undermine the expectation that the oil oversupply will be absorbed at the end of 2016 or at the beginning of 2017, and any supply increase thereafter will require a price higher than the USD 52-53 per barrel of Brent seen in 2015. While it is difficult to predict the rate of oil price growth in the coming years, it is easier to forecast the price level in the long term. The reason is quite simple. Today, no one can even imagine the world without oil. Even in the ‘450 Scenario’ developed by the International Energy Agency being the “greenest” scenario of a far-reaching transformation of the global power system, the world is anticipated to consume 83.4 mbd of oil in 2040. This would be 8.7 mbd less than in 2014. We have known for a few years now that this scenario has no chance of playing out. But if it did, some 40-50 mbd of oil would need to be extracted from new fields by 2040 because the currently producing fields are depleting.
According to more realistic scenarios, global oil demand would peak after 2030, with an adequately higher production from new fields required to satisfy this demand. That would necessitate tapping more and more demanding deposits, whose production will be more and more expensive. The full cost of producing very heavy Venezuelan crudes is currently estimated at over 100 USD/bbl, and that after factoring in the expected drop in production cost in 2015−2016. This is why in my opinion average annual price of oil is more likely to be around 100 USD/bbl than the current 50 USD/bbl.adamczyzewski