Tuesday, 25 November 2014

Will oil price stay “low”?

If the new consensus is right, the era of a triple-digit oil price is over

Oil price has fallen to around $80 per barrel from its peak of $115 in mid-June. While the new price is not particularly low by long historical standards, it does seem low in comparison with the recent past given that it had stayed above $100 for most of the three and a half years prior to the fall. So is the recent sharp fall a result of temporary factors or a reflection of deeper fundamental forces in the oil market?

A new consensus has emerged arguing that a below $100 price is the new norm. The view suggests that changes in the landscape of the global oil market—particularly on the supply side—are leading to a lower equilibrium price, estimated to be in the range of $80-90 per barrel. This view is based on three propositions about the market over the next few years.

1. The US oil production will continue to grow, mostly due to shale oil. The shale revolution is reducing the US reliance on imported oil, creating oversupplies elsewhere. While this process has started in the mid-2000s (see the chart), other factors were at play keeping global oil price high (demand from China and other emerging markets, supply disruptions in the Middle East and so on). With these factors receding, the continuous growth of shale oil is expected to keep oil price lower than in recent years.

2. Shale production will still be profitable at the new equilibrium price range. Shale oil is costlier to extract, but the process is becoming more efficient. While there is a great deal of uncertainty about the minimum price at which the extraction of shale oil is profitable for producers, the new consensus suggests that it could be around $80. This means that at the new equilibrium range of $80-90, shale oil is expected to continue growing, although at a slower pace than in the last few years. Only a sustainable drop of oil price below $80 would make some shale investments not viable leading to production cuts.

3. There will be no supply shocks (positive or negative) from the Middle East. The new consensus assumes modest production growth in Iraq (0.2m b/d each year) and a stabilisation of Libyan production at around 0.7m b/d. It also assumes no production growth in Iran.

Given these assumptions, the new consensus expects oil to trade mostly around its equilibrium range of $80-90, with possible temporary deviations due to the occasional build-up of inventories or exceptional weather conditions.

There are risks to this view. On the downside, further decline in shale production costs or a lifting of the sanctions on Iran could result in more global supply and a further decline in price. On the upside, supply disruptions in Iraq or Libya could lead to a higher price, as could an aggressive reaction by OPEC to the price fall.

OPEC is meeting on 27 November and observers are evenly split about the likelihood of a production cut. But even if the organisation surprised with a production cut, it is not clear if its action would be enough to turn the tide caused by the shale revolution. If the new consensus is right, the era of a triple-digit oil price is over.