What is really going on with oil prices?

What is really going on with oil prices?

As commodity prices have fallen globally over the last year, the one commodity that has stood out from the rest, which is often the case, has been crude oil. OPEC oil prices fell to a 14-year low on 20 January with the OPEC oil basket falling to USD 22.5. Many have cited the oversupply of oil as the reason for the price plummet, as well as uncertainty over the global economy resulting in decreased demand. The laws of supply and demand say that as supply increases and demand decreases, prices decrease. Despite the gradual decrease in prices over the last year, oil producing countries have continued with output at record high levels to gain as much market share as possible on competitors. The competition for market share even among fellow OPEC members was evident as production continued at record highs. Since February, however, a potential deal between Russia and key members of OPEC, including the unofficial leader Saudi Arabia, to freeze oil production at January output levels was announced to try to combat the low-oil price environment and stabilize prices at a higher level. Negotiations to finalize the deal happen in Doha on 17 April, but those ended without an agreement, despite many believing a deal was a foregone conclusion before the meeting even took place.

Falling investment in oil production

One consequence of the low-commodity-price environment has been changes in investment. As prices have fallen, there has also been a general downward trend in investment in the fossil fuel energy sources like oil.


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According to FocusEconomics Economist Robert Hill, “Changes in oil investment have been largely heterogeneous across countries since the collapse in prices, for example, Iran has witnessed a surge in energy-related investment since sanctions were lifted and other countries are pushing ahead with extraction-related projects that will come online in the longer term. However, oil-related investment activities are trending downwards in a number of countries.”  

Maybe, however, there is a bigger issue at play here? Over the last decade or so, the need for green energy has become more apparent as many scientists have identified human activity as the cause of climate change. It has been speculated that part of the reason for less investment in oil production has been aided by a movement toward green energy sources and, and indeed there has been a movement of this kind. According to numerous reports, since the climate change meetings in late 2015, a coalition of major oil-exporting countries have begun looking to invest in green energy like solar power and wind energy. These nations have also cut water and electricity subsidies, imposed energy conservation measures, and pushed home owners to buy solar panels to generate power at home. However, the movement away from investment in oil production hasn’t been so much about the sustainability of future generations by cutting greenhouse gas emissions.

“This movement (away from investment in oil) is not so much related to the fall in energy prices in the past year and a half nor is it about cutting greenhouse gas emissions, but expectations that the supply glut will linger over the next year. This is what producers look at and it is what has driven down expansionary capital expenditure in the energy sector. Some analysts foresee this leading to a shortage in the future, if producers underestimate the future demand for oil,” says Hill.

Is there an energy crisis on the horizon?

While these oil-exporting countries are beginning the process of cutting investment in oil production, the oversupply of oil continues and demand may stay low for the foreseeable future. So, if prices continue at their current levels, is there the possibility for an energy crisis on the horizon?

“After prices began their decline in 2014, the IMF predicted that it would lead to a period of strong growth, as developed economies, and some major emerging economies, used cheaper energy to fuel their economies. This prediction has fallen short of the mark. Falling capital expenditure in the energy sectors in places such as Canada, Norway and across the Middle East have done more to harm these economies than help them. Other countries have not seen the boost that cheaper energy was supposed to deliver. However, I do not foresee an energy crisis per se.

“The technology that has enabled extraction from shale fields and tar sands will not disappear and will put a ceiling on prices going forward, so it is not likely that prices will climb to the over USD 100 per barrel highs of the previous decade, and the price floor under USD 25 dollars a barrel was already reached earlier this year in January. This should keep energy prices within a comfortable price range for the foreseeable future, warding off any potential impending energy crisis,” said FocusEconomics’ Robert Hill.

What has OPEC really been up to?

Mentioned previously OPEC is now keen on bringing up oil prices, however, this will be difficult. In response to their market share shrinking as a result of higher cost producers setting up across the U.S. and Canada, OPEC attempted to drive down the price of oil and push these higher-cost producers out of business. This seemed to be working for a time, according to the Baker Hughes Index, a measure of the number of rigs across North America, the number of rotary rigs operating in the U.S. and Canada plummeted in early 2015, but since then the figure has been relatively stable. The technology and legislation that permits higher-cost oil extraction cannot be undone, which in effect puts a ceiling on the prices of oil.

Should the oil prices climb higher than the recent average, more competition may enter the global energy market and drive down OPEC’s market share. If prices fall too low, then OPEC countries don’t get the revenue they need in order to support their economies. OPEC members are now exploring the possibility of freezing oil production at January 2016 output levels along with Russia in an attempt to get oil prices closer to, but still below, the figure at which higher-cost producers become profitable again.

At this point you might be asking yourself, “Does OPEC and Saudi Arabia really see the US as such a big threat that they would ideally like the price of oil not to go up too much?” The answer to that question lies with fracking. Although oil production costs are constantly falling as new innovations and technologies are adopted, shale fracking in the Northern U.S. generally requires the prices of oil to be above USD 70 per barrel for it to be profitable basically meaning that Saudi Arabia and OPEC members can squeeze US producers out of the market with lower-prices.

According to Robert Hill, “Oil prices will probably not rise to a profitable level for U.S. shale fracking oil producers until after the end of 2017 as oil stockpiles are still high, and cheap oil producers are still pumping at near-capacity levels. As a result, we may see more U.S. producers dropping out in 2016 leaving opportunities open for OPEC to exploit the vacated share of the market. However, unless anti-fracking legislation is passed in the U.S., fracking is probably not going anywhere, meaning that once oil forecasts start breaching the USD 70 per barrel mark, one might speculate that these US producers would return to operations."

One might also speculate that OPEC is preparing for a future in which fossil fuel energy is no longer the dominant energy source. Anthony Hobley, Chief Executive of Carbon Tracker Initiative was quoted as saying in The Guardian, "The writing is clearly on the wall that we are facing the end of the fossil fuel era." His assertion is aided by the fact presented earlier that top oil exporting nations are moving away from fossil fuel energy within their own borders, possibly in a move to reduce domestic demand so as to export as much oil as possible. Hobley goes on to say, "if your economy depends on (fossil fuels) it would be prudent in the extreme to plan for that transition (the end of the fossil fuel era) while you still have respectable revenue." The move to squeeze US high-cost producers out of the market may be a move in a bigger, longer-term plan to prepare for a future global transition away from fossil fuel energy consumption. If we put all that together, OPEC could export as much oil as possible, with little competition, while not burning much of it at home.    

What would OPEC like to see happen in the short-term?

So, what is it that Saudi Arabia, the unofficial leader of OPEC, would like to see happen in the next year to two years? Ideally they’d like to see prices rise quickly to around the USD 60 level, but given that this isn’t only about tweaking supply to bring up prices, as was mentioned earlier, Saudi Arabia must also contend with slipping demand as well. Global growth has been revised down for the next two years in the latest FocusEconomics Consensus Forecast Major Economies to 2.7% in 2016 and 3.1% in 2017, indicating the demand for energy is also weaker than expected. So, although bringing the prices of oil higher by another USD 20 per barrel should take some pressure off of government revenues in oil dependent countries, the chances of this happening in the next two years appear to be slim.

Summing everything up...

What does Economist Robert Hill think is likely to happen in the near future?

“Production is actually falling in some parts of the world currently, and in others it is being maintained at capacity levels. This means that overall there is less hydrocarbons being extracted and also less investment into upgrading and expanding operating oil rigs, which will mean even less output in the future. Demand should pick up later on this year as a nascent global recovery takes shape, which means that demand could outstrip stockpiles of oil and the prices could increase. We may see prices spike a bit, however once it becomes profitable for producers to turn the taps back on in U.S. and Canada, we should see prices stabilizing at a more longer run equilibrium.”

We will just have to wait and see.

 


commodities_cover_focuseconomics.jpg

Download

FREE Sample - Commodities Report

Download a sample of our new Consensus Forecast Commodities report

33 commodities in the energy, metals & agricultural sectors

Price forecasts, historical data, & written analysis

 

Further reading:
What is the difference between WTI & Brent Crude Oil?
Energy Commodities
Brent Crude Oil
WTI Crude Oil

Date: April 20, 2016


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