What has driven the dramatic fall in oil prices since June this year? Some see it as a sinister portent for the world economy, whilst others point to a supply glut, in part a function of the US onshore production miracle of the last decade. We explore both sides in detail and find that OPEC obituarists may be premature.
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Understanding recent oil price moves
Having reached 2014 highs in June, crude oil prices started to free fall. In the search for explanations, some commentators have pointed towards the International Energy Agency's (IEA) changing demand and supply expectations. Since June, when the IEA's 2014 global oil demand growth forecast hit a peak of 1.4 million barrels per day (mb/d), its projections have fallen by half, with Europe and Asia accounting for the bulk of the adjustment. In contrast, supply expectations have been much more stable: since June, the IEA's forecasts of non-OPEC (Organisation of the Petroleum Exporting Countries) oil supply growth have expanded by a modest 300 thousand barrels per day (kb/d), and the IEA's non-OPEC supply forecast is currently only 100kb/d above the level at which it started 2014. Thus, according to the IEA, it is the demand side of the equation that is primarily responsible for the 40% decline in crude oil prices since the summer. (Figure 1)
“OPEC's most at-risk countries (Iraq, Iran, Libya and Nigeria) have made strong production gains in recent months”
Other commentators emphasise that production amongst OPEC's most at-risk countries (Iraq, Iran, Libya and Nigeria) has made strong gains in recent months. (Figure 2) This was despite rising violence in both Iraq and Libya. The OPEC cartel’s decision not to act at its hotly anticipated regular meeting on November 27 saw oil prices plunge further. Plenty of the ensuing commentary has focused on the idea that OPEC has somehow lost, or is fast losing, its relevance to an oil market increasingly in thrall to burgeoning US onshore production potential.
We suspect it may be too early to write off OPEC – the key actor in world crude oil markets for over four decades now. The cartel comprises 12 of the world's biggest oil-producing nations, including all of the major Middle Eastern states, Venezuela and Nigeria. According to OPEC, the cartel controls 81% of the world's known oil reserves and accounts for about a third of the world's oil sales. The major oil producers not in OPEC include Russia, Canada and the United States. By restricting the output of its members, the cartel has, at times, been effective in significantly increasing the price of oil. This happened from the 1970s into the 1980s, and the price explosion over the past decade is evidence that the cartel has been back in business until recently. Figure 3 shows oil and natural gas prices on the common scale of energy content (also known as energy density or the potential energy contained in a fuel) and demonstrates the still-elevated level of oil prices relative to history.
Within OPEC, it is Saudi Arabia that has always been seen as the lynchpin, with the largest share of OPEC output and the only OPEC producer with significant spare capacity. (Figure 4) The Saudis have been widely thought to require Brent crude prices of at least $90-$100 to balance their budget. When this supposed ‘floor’ was breached in October with still no hint of Saudi supply response, the world of many oil price forecasters was turned upside down as further, more dramatic price declines attest.
A new era of renewed energy abundance?
Saudi Arabia’s reasoning behind not acting this time is key to understanding the likely future path of oil prices. In the absence of much in the way of official illumination from Saudi Arabian officials, all manner of theories have filled the void. According to some estimates, the imbalance between oil demand and supply is not particularly large in the short term, leading some to claim that Saudi Arabia should have been able to force oil prices back above $100 per barrel with a one-off cut of its production of no more than 1.5 million barrels a day. For those, such a cut would have been enough to balance markets at least for the year ahead. Others suggest that Saudi Arabia is still haunted by its experience in the 1980s, when its attempt to prevent a steep drop in oil prices failed, despite slashing production by almost three quarters. While the Saudis’ motives remain shrouded in some mystery, Kuwait’s oil minister, Ali al-Omair, has been quoted as saying that he opposed production cuts because such a move would not necessarily be effective to prop up prices – to many, an admission of OPEC’s declining influence on the global oil market.
It is hard to overstate the degree to which the North American boom in new unconventional supply (mostly Canadian sands and US light tight oil [LTO, aka shale]) has consistently defied expectations. In the IEA's 2014 medium-term oil market report, the baseline of US and Canadian production for 2013 is 300 kb/d more (circa 2%) than had been expected in 2013, 420 kb/d greater (c. 3%) than forecast in 2012, 2.2mb/d higher (c. 18%) than anticipated in 2011 and 3.21mb/d (c. 29%) above 2010 projections. This shows why the unlocking of this new resource is often described as having ushered in an era of renewed energy “abundance.”1
Less than ten years ago, the United States was the world's largest importer of refined products, with 2.5mb/d of product inflows in 2005. Its crude production seemed in inexorable decline. Today, according to the IEA, the US has become the world's largest liquids producer, ahead of Saudi Arabia and Russia, as well as its largest product exporter. In 2013, US production rose above 9 million barrels a day for the first time since 1986, according to the Energy Information Administration. The EIA predicts that US production will reach its highest annual average since 1972 in 2015. Since some estimates suggest LTO resources in the US may not amount to more than about 15% of the world total, understandably many countries with a promising shale and/or tight oil endowment are now trying to replicate the US success story. Several are taking policy steps on the tax and regulatory front to hasten the development of their non-conventional potential. Such aspirants will no doubt benefit from the trail that the US has blazed, both in terms of knowledge base and technological advances.
The US and Canada have been the largest contributors to non-OPEC production growth over recent years. (Figure 5) We are only beginning to see overall increased production growth, because at the exact same time, geopolitical conflicts have been flaring up in key oil regions such as Iraq and Libya, with sanctions on Iran further crimping Middle Eastern supply. In total, there have been up to 2.7mb/d unplanned OPEC production outages in recent years. (Figure 6)
Demand weakness may not be all that it seems…
Oil’s characteristics make it particularly well-suited for the production of transportation fuels. With very few ready substitutes in the past, this is oil’s predominant usage today. (Figure 7) Looking forward, it is easy to see technological advancements prompting increased inter-fuel competition. Plentiful gas will likely increasingly displace oil at the margin in the US transport sector, including rail and road freight, a prospect that would have seemed unthinkable a few years ago. In OECD Europe too, oil continues to be pushed out of stationary uses in favour of gas and renewables and may begin to lose its grip at the margin on the transport sector.
Increased energy efficiency is the other headwind to oil demand. Energy efficiency, as measured by primary energy consumption per real dollar of gross domestic product, has steadily increased in the US since the 1980s. (Figure 8) In the auto industry, average fuel efficiency levels increased 35% in Europe and 42% in Japan between 2000 and 2013.2
The average fuel efficiency of airplanes has improved 70% during the past 40 years.3
Efficiency gains and the switch from crude oil to natural gas and biofuels have cut the
consumption of petroleum products in the United States by more than 2 million barrels per
day since 2005, according to the Energy Information Administration.4 If consumption is
adjusted for the rise in population and economic output, oil use has actually decreased by
between 3 and 4 million barrels per day compared to the previous trend.
The prospects for future oil demand hinge on the emerging and industrialising world,
where strong population growth and increasing urbanisation are seen as more likely to
lead to increasing overall demand. To this end, non-OECD demand now accounts for the
majority of world oil consumption. (Figure 9) However, China, the single largest source of
incremental oil demand in recent years, has clearly entered a less oil-intensive stage of
development. In large part, this is a regulatory and legislative response to the
environmental problems resulting from China’s rapid industrialisation. According to
Gavekal Research,5 in China, the “oil intensity” of GDP – apparent crude oil demand
divided by real GDP – has been declining at a 3-6% annual rate for the past decade, a
pretty impressive pace of efficiency improvement. Simply put, a 7% GDP growth for the Chinese economy does not mean what it used to mean for oil demand. China targeted a 20% decline in the overall energy intensity of GDP from 2005-10 and achieved 19%. A further 16% reduction is targeted for the 2010-15 period.6
The path of energy efficiency savings can be quite uneven over time. (Figure 10) In the past, it was higher oil prices in the form of the oil shocks that led to high per-annum fuel economy increases. When oil prices decreased, efficiency targets became less demanding. Increasing worries around pollution and global warming may change this, with new fuel efficiency standards unrelated to the oil price. As a result, even if oil prices drift lower, governments in the advanced economies are unlikely to relax the push for efficiency because it is central to their climate change strategies.
Where supply goes from here…
While Saudi Arabia’s unwillingness to carry the burden of balancing oil markets alone became apparent to markets in September, oil prices continued their fall the following months, experiencing a particularly large drop following the OPEC meeting on November 27, 2014. This corresponds with the market increasingly realising that no other market participant would voluntarily participate in reducing production to balance oil supply and demand.
Relations between Russia and Saudi Arabia have cooled over Moscow’s support for Syrian President Bashar al-Assad. Nevertheless there had been expectations that Russia might participate in a supply reduction: Russia is already suffering from Western sanctions over its actions in Ukraine, and according to President Putin, needs oil prices of a little over $100 per barrel to balance its budget. These hopes faded when Russia’s most powerful oil official Igor Sechin, chief executive of Russia’s largest oil producer Rosneft, said that Russia wouldn’t need to cut output even if prices fell below $60 a barrel.
Expectations regarding the November OPEC meeting had not been particularly high, with many long suspecting the cartel of dysfunction. Nevertheless, there had been hopes that the communications following the meeting would at least convince the market that OPEC understood the scale of the problem and had an effective mechanism in place for agreeing and enforcing lower production levels in the future. In contrast to this, the OPEC statement made no mention of any extraordinary meeting to reconsider the ceiling before the next regular session on June 5, 2015, nor did it address the need for members to stop overproducing relative to targets set.
According to media reports, Venezuelan Foreign Minister Rafael Ramirez left the November meeting visibly angry and declined to comment on the outcome, demonstrating a clear rift within OPEC. The underlying issue is that the ability to withstand lower oil prices differs widely amongst OPEC members. Thanks to their large foreign currency reserves and sizeable sovereign wealth funds, Gulf producers can withstand lower oil prices for some time, whilst members without such a cushion will find it more difficult, as will a number of producers outside the group.
“The stage is set now to see a fight for market share within oil markets”
All eyes on US shale oil going forward
The OPEC meeting set the stage for a fight for market share within oil markets. The important point to understand is that in an oversupplied market, prices should trend toward the total average cost of the marginal high-cost producer; however, in the short term, prices can obviously fall further.
This idea is based on producers having two sets of costs: capital expenditures, which represent the investments before production starts, and operating costs during production. Capital expenditures represent sunk costs (costs that cannot be recovered), and thus in the short term, producers have an incentive to continue producing, as long as oil prices don’t fall below operating costs. According to Morgan Stanley,7 the higher end of operating costs is close to the $35-$40 dollar per barrel area. However, we suspect few producers are willing to test these levels and expect Brent crude oil to find solid support in the $60-$70 range over the next 6-12 months, assuming current, relatively conservative demand estimations are accurate. In the long term, producers will seek to recover both capital expenditures and operating costs, pointing to a higher trading range (though cost forecasts are as unreliable as demand forecasts in the long run).
Unconventional producers tend to have high production costs, with Canadian oil sands costs being amongst the highest and US LTO comprising a considerable chunk of oil with high production costs. There is no lack of estimates as to the price level at which US shale oil production could be forcibly curtailed. The problem is that they all appear to be different. A debate was ignited by OPEC, after comments from Secretary General El-Badri at a conference on October 29, who observed, “If prices stay at $85, we will see a lot of investment, a lot of projects, a lot of oil going out of the market.” He suggested that as much as half of shale oil would be out of the market at a price of $85. This view is at the high end of the range when it comes to estimates, with the IEA seemingly taking the other side. In its October oil market report, IEA states that only slightly above 4% of US LTO production faces a break-even price of higher than $80 per barrel. (Figure 11)
There are obviously many issues that complicate this discussion. For example, some US producers are currently managing to survive because they were able to hedge the prices they get for their oil. When those arrangements expire, life will become much more difficult. The other issue is that there is a precarious feedback loop between oil prices and funding costs. With oil prices heading lower, yields demanded by investors increase.
So where does this leave us? Despite wide-ranging estimates, consensus indicates that some degree of US shale oil production will be impacted at current oil price levels. It is yet to be seen whether this translates to a mere slowing in the rate of oil production growth due to lower future investments or a more material crimping of production. All eyes will be on LTO data going forward, with some commentators stating that rigs are already being idled and capital expenditure has been cut. The further development of US production will have a material impact on the spread between oil prices in the US and internationally. (Figure 12)
The continued strength of the US dollar shields some higher-cost producers from what otherwise would be a much bigger decline in revenues. In particular, the rapid decline in the value of the Russian ruble means that Russian producers are unlikely to be suffering enough to start considering the production cuts they otherwise might have to. On the demand side, there is the opposite effect. Emerging market currencies like the renminbi and rupee have not weakened nearly as much as the euro, and so consumers in China and India have seen domestic commodity prices fall by at least as much as the equivalent dollar decline, if not slightly further. There has been greater sensitivity to fluctuations in international oil prices following the removal of subsidies in these two countries, in China as far back as 2011, but in India as recently as October 2014. As a result, prices in domestic currencies are considerably lower compared to the oil price peak in June. The longer low prices persist, the more likely we will see a material demand response. According to JP Morgan Asset Management research,8 a $10 fall in oil means that major consuming economies will grow by an additional 0.5% a year at the expense of the major oil-exporting nations.
Alongside all this, short-term upside risk to oil prices remains due to the possibility of unplanned supply disruptions. Libya’s chaotic conflict and risk to oil infrastructure remains the biggest geopolitical wild card for the oil market. Dynamics on the ground in northern Iraq indicate that the fight against ISIS is likely to extend for a long time. Risks to southern Iraq oil facilities have for the moment abated after the counteroffensive military operations and air strikes in the north, but this shouldn’t be taken for granted. In any case, we expect basic infrastructure bottlenecks (especially the lack of pumping capacity and storage) to become a limiting factor on growth in southern oil exports. Another effect to consider is that as prices fall, outage risks rise. In particular, Venezuela and Nigeria are not self-sufficient regarding gasoline, and their populations have become accustomed to very low gasoline prices (especially in Venezuela). Low oil prices could squeeze finances and force subsidies to be lifted, which could lead to civil unrest or production disruptions. In Nigeria, a modest change to subsidies a few years back was met with large protests and their eventual reinstatement. Venezuela has a long history of protests over even small changes in gasoline pricing.
What does it all mean?
The factors affecting the oil market are difficult to convincingly nail down. Estimations of both demand and supply are ever-changing for a multitude of reasons, with Middle Eastern geopolitics and US onshore production just two of the more popular current themes.
We would urge readers not to underestimate the role of Saudi Arabia. The Kingdom is still where most of the world’s spare capacity resides, and authorities there still have the potential to influence markets in a way no other single producer can.
As suggested above, we can certainly see oil prices weakening further from current levels in the near term; however, looking further into 2015, current levels look more likely to represent a base level. Our suspicion that the global growth potential for the next couple of years is currently being underestimated may help oil prices drift up from here, though as suggested above, many other factors are also at play.
In terms of ramifications for the world economy and asset markets, the 40% drop in the price of a barrel of Brent crude since the summer implies a windfall for global oil users of c. $1.5 trillion.9 There are regions, such as the US, where the consumer will feel this effect the most profoundly, and others such as India, where government budgets benefit the most. However, the point is the oil price fall should be good for global growth in aggregate.
For capital markets, the equation is more complex. Most of the fixed income complex seems to be welcoming the extra deflationary pressure provided by the falling oil price (with the obvious exception of parts of the corporate credit space exposed to US onshore drilling), while equity markets have laboured somewhat under their exposure to the energy sector. In the context of our more positive view on global growth, a view supported by the falls in oil prices, we suspect the outlook for equities still looks significantly more appealing than it does for fixed income. Within the energy space, there are obviously some names that have fallen a long way. While the sector as a whole is likely to continue to dance to the tune of the oil price, opportunists with a strong stomach may well sense some value opportunities out there.
1 Source: IEA Medium-Term Oil Market Report 2014.
2 Source: International Council on Clean Transportation, Credit Suisse; as of 29 September 2014.
3 Source: IATA Technology roadmap 2013, Credit Suisse; as of 29 September 2014.
4 Source: EIA, Reuters; as of 23 September 2014.
5 Source: Gavekal Dragonomics; as of 12 November 2014.
6 Source: Gavekal Dragonomics; as of 12 November 2014.
7 Source: Morgan Stanley; as of 27 November 2014..
8 Source: JP Morgan Asset Management research, the telegraph; as of 14 November 2014.
9 Yardeni Research, as of 9 December 2014.