The Future of Oil Prices
The Future of Oil Prices
The fluctuations in the price of a barrel of oil impacts global economy more than any other commodity. Historical evidence suggests a sharp increase in oil prices is followed by a global recession, while any significant reduction in oil prices leads to expansion in the global economy. The combinations of unbridled speculation by hedge funds and shocks in the short run have pushed oil prices below the natural clearance level.
The energy market has always witnessed a turf war between monopoly and competition. It would be appropriate to analyse the movement in inflation related oil prices since 1974. During the period 1974 to 1985, US benchmark oil price oscillated between $50 and $120 in terms of current money, while from 1986 to 2004 – the range was $20 to $50. Again, between 2005 and 2014 oil prices was between $50 and $120. To conclude, the trading range between 2005 & 2014 and 1986 & 2004 are similar. The key difference however is the shift from a monopoly to competitive pricing in 1985 – OPEC losing control due to the availability of new oil sources – North Sea and Alaska. Again, the trend was reversed in 2005 due to huge demand for oil from China, enabling OPEC to regain control.
Thus, $50 would be the dividing line between the monopolistic and competitive system. The prices would match marginal costs in a scenario of high competition. In other words, the price would highlight the costs an effective producer must incur to supply each barrel of oil needed to meet international oil requirements. On the other hand, in a monopolistic economy, the stakeholders can select a price that is more than the marginal costs and control production, thereby ensuring supply is less than demand.
Until recently, oil was produced within a monopoly price regime, since Saudi Arabia was the key producer – keeping supply less than demand. However, this provided an opportunity to oil producers in North America to increase output significantly. The Saudi pricing policy acted as an incentive for North American producers to make huge profits through development of shale oil.
In turn, Saudi Arabia could sustain high prices by decreasing their supply to the global market which was quickly met by oil from the US. This made Saudi Arabia realize the impact on the geopolitical scenario – The US replacing Saudi Arabia as the largest producer would mean less incentive for the US to safeguard Saudi Arabia.
The Saudi Arabian government is not committed to reversing the trend as was evident during the recent OPEC meetings. OPEC has no choice but to reduce prices to the lower limit which would force producers in the US to cut production and thereby match international supply & demand. In other words, Saudi Arabia would not want to act as a swing producer and pass on that role to US frackers.
The technical reason for that is – Shale oil is very expensive and would be touched only after the global low-cost conventional oilfields are operating at optimal levels. The competition in the market would make Saudi Arabia and other cost effective suppliers maximize production while the shale gas producers in the US would be affected by market fluctuations - decreasing production when demand across the globe is less and spiking production when demand is at its peak.
Thus, the marginal cost of US shale gas would be the upper limit for international oil prices, while the cost of inaccessible and marginal conventional oil fields (OPEC and Russia) would be the bottom limit. Since, the expected shale oil production costs is around $50 and breakeven point for marginal conventional oilfields is $20, the new trading range could be $20 to $50.
Growth Factors and Challenges for the Oil Market
International oil price movements are affected by many factors – the balance of supply & demand, the prevailing macroeconomic and geopolitical scenario, the stability of the US dollar exchange rate and the health of financial markets globally. Advancements in technology have assisted in exploring huge reserves.
• Rising global population
• Expanding urban pockets
• Enhancing transport infrastructure globally (particularly Asia)
• Increasing costs of exploration and production
• Broadening OPEC policy
• Depreciating dollar
The population is increasing expeditiously. The global population is projected to expand by 1.1 billion between 2010 and 2025. A significant percentage of the growth would be in developing nations – India is expected to become the most populous nation by 2020, while the population would be comparatively stable in developed nations. Developing nations will also witness a relocation of rural population to the major cities – urbanization.
Again, consumption levels would also witness significant growth. By 2025, the urban consumer segment would have grown by 1 billion while the middle class on the whole would account for over 50% of the global population. Increasing spending would fuel demand for properties, infrastructure, vehicles, luxury goods and in turn for energy.
The demand for oil would increase yearly by 1.2% and is projected to reach 105 mbd by 2025.
Among the sectors, the transport sector would witness the maximum demand for oil (more than 90%). Oil consumption will significantly increase in developing nations – transportation sector and industrial expansion (particularly petrochemicals).
However, oil consumption in developed nations would be less, due to low levels of economic growth. The driving force in increasing demand for oil would be motorization of the population in emerging economies. China and India would see significant improvement in automobile purchase. Freight cars (projected to grow by 140 million - 2025) would also contribute to the increase in motor fuel consumption.
Enhancing fuel consumption efficiency
Advancements in automobile technology – improvement in engine designs, better quality of engine fuel and breakthroughs in hybrid technology have resulted in fuel economy improvement – it is estimated fuel consumption would decrease by 30% (2025).
Cost of upstream operations
The costs of exploration and production have skyrocketed in the last ten years. One of the reasons being decrease in conventional oil resource base. Increasing demand for oil is forcing the Oil & Gas sector to tap unconventional and extremely costly reserves - oil from deepwater shelves, managing high viscosity oil fields and securing oil from tight reservoirs.
The pioneering breakthroughs in horizontal drilling and hydraulic fracturing technologies have made the production of shale gas profitable in the US. A salient feature of shale oil reserves is the low permeability and hence hydraulic fracturing technology is utilized to enhance the oil inflow.
Deep water production
Increasingly, onshore reserves have less production capacity, against this context offshore resources would play a vital role in catering to the increasing demand. The commercial prospect of shelf reserves is gaining importance. In fact, in the last 20 years, the total mega shelf discoveries have been more than the total mega onshore discoveries. Currently, the value of confirmed offshore reserves is 280 billion barrels, while shelf production accounts for 30% of the global production. Due to technological advancements, nearly 27% of the shelf production occurs at a depth of 300 m.
OPEC’s strategic role
At present, OPEC monitors over 42% of the international oil production. Hence, cartel members can expeditiously negate any changes in market scenario (establishing production quotas). Oil prices are a key factor during the budget revenue planning of OPEC countries.
The GTL challenge
GTL technology – refining methane from natural gas and converting into a wide range of products including kerosene and diesel with better environmental results has a great potential to substitute oil fuels. It was used in the 1940’s in Germany during WWII. The strict environmental regulations and the potential to operate gas fields in locations without a strong gas transportation infrastructure have rekindled the significance for the technology. Though, in the near future GTL would not challenge the oil sector, the advancements in methane conversion methods could alter the scenario in the long run. GTL technology is expected to have a great impact on the oil sector after 2020.
The power of dollar
Oil prices being denominated in USD, the volatility in the American currency exchange rate would impact the international oil prices. For example: between 2000-2012, the price of oil measured in USD increased 3.0 times while the price of an oil barrel measured in Swiss Francs increased by 2.2 times. A depreciating dollar due to US monetary policy would lead to oil prices growth.
Break up of demand for oil products
Between 2012 and 2025, international oil product consumption would increase by a yearly rate of 1.2 % on an average. Middle East nations using fuel oil for power generation, manufacturing, desalination plants, fuel for refineries will see an increase in the consumption of fuel oil products. The demand for diesel would grow at an accelerated rate in comparison to other oil products. The percentage of diesel in the international oil product consumption would increase from 32% to 37%.
Refining capabilities across the globe
It is projected that between 2012 and 2020 the yearly net increase in international oil refining capabilities would amount to 1 million barrels per day. A significant increase in the refining capabilities would be in the Middle East and the Asia Pacific region.
The CEO of the Italian Oil & Gas conglomerate - ENI Claudio Descalzi, forecasts the oil prices to hover around $200 in the next 4 to 5 years. He also recommended the establishment of a central bank of oil for ensuring stability in the long run.
According to President of Saudi Aramco - Khalid Al Falih, the two factors – financial leverage and discontinuation of quantitative easing have expedited the fall in prices.
The Chief Economist of International Energy Agency, Fatih Birol stated “the fall in oil prices is due to several reasons – highest supply of oil in the last 30 years, slowdown in Chinese economy, recession in Japan and slow progress in Europe’s recovery”.
The Chief Oil Analyst at Oil Price Information Service - Tom Kloza said “oil prices are likely to fall further this year before they recover”.
OPEC’s Secretary-General - Abdulla al-Badri said “Oil’s second largest recorded decline might be coming to an end. He also warned of an increase in prices to $200 a barrel if investment in supply capability stays low”. The Russian deputy prime minister, Arkady Dvorkovich, opined “Oil is not going to go to minus $40”.
Oil prices have been swinging both upwards and downwards in February 2015. Oil experts expect the rollercoaster to continue. As per a statement issued by Tom Kloza, Chief Oil Analyst at Oil Price Information Service, "cycle has a long way to run out". He further stated “the spread between Brent and WTI could widen to about $10”.
The IEA felt “rebalancing of supply and demand can take months, if not years, and even after rebalancing, the oil market would "never be the same as what it was".
John Kilduff, Partner at New York energy hedge fund - Again Capital LLC, informed the news agency – Reuters "a good reminder that there's still a lot of supply to come and it doesn't give much hope for the bulls who say we've hit bottom and are now on the way up".
An internal finding from Goldman Sachs concluded “a sharp drop in US oil rig counts has helped lift crude prices off their lows in recent weeks, but would not slow production or alleviate oversupply”.
During a presentation at the yearly International Petroleum Week industry conference in London 10th February 2015, the Chief Executive of the mega oil trading firm Vitol, Ian Taylor predicted a “dramatic" build in global oil stocks over the next few months amid high US production and weak demand”.
Oil experts warned crude's "rollercoaster ride would continue as it tries to find a bottom to a seven-month sell-off that took prices near six-year lows”. The Wall Street Journal stated “short-term traders, who are quick to pile into a bounce and just as quick to pull out on any sign of a reversal, are exacerbating the volatility”.
Donald Morton, Senior Vice President at Herbert J Sims & Co told the Wall Street Journal that the market was "yo-yoing" but suggested it was most likely a "sympathetic bounce".
James Marshall, Partner at brokerage Atlas Commodities LLC, explained: "Nobody wanted to miss coming off the lows. Nobody wanted to be that guy that watched it fall 50 per cent and then watched it rally 20 per cent and did nothing."
Huge amounts of gas are wasted on a daily basis due to flaring at production sites. The Oil & Gas sector is lagging behind a 2030 goal of stopping the practice. As per a report presented by the World Bank “The total gas flared each year is enough energy to supply electricity to several small countries or many millions of households”.
The flaring of 140 billion cubic metres (bcm) a year releases huge amounts of greenhouse gases into the environment, which is detrimental to the environment in the long run. The IEA felt $4.1 trillion investments is required between 2010 and 2030 to check greenhouse gas consolidation at 550 parts per million (ppm) of carbon-dioxide (CO2) equivalent. In order to decrease consolidation to an accepted level of 450 ppm, an additional $2.4 trillion would be required to establish low- or zero-carbon power plants and $2.7 trillion to have energy efficient equipment.
Long term outlook for fracking
The price of oil currently is around $50 per barrel, but fracking companies require prices to be in the range of $60 to $100 to break-even (Climate News Network). It is evident that the fracking technology – process which enables Oil & Gas deposits to be blasted from shale deposits deep under the earth’s surface has enhanced global energy supplies. However, experts are warning of monetary fallout impacting the financial wellbeing of the fracking sector.
In other words, the fracking boom contributed to increase in global oil supply. The slowdown in the global economy, particularly in China means less demand and over supply which has led to prices crashing by 50% in the last 6 months. Fracking has been hit hard due to its own success. Due to fracking, the US oil production which stood at five million barrels a day in 2008 has almost doubled, resulting in US becoming the largest producer of oil in the near future.
Investors from across the globe have made huge investments in fracking with expectations of excellent ROI. It is estimated that the fracking sector in the US accounts for over 20% of the global crude oil investment. Financial experts have warned the complete investment scenario might collapse. The mega fracking firms might withstand in the short run, but thousands of smaller fracking firms who entered the sector with an eye on big money might have to wind up.
The policy decision of OPEC has added to the woes of the fracking sector. According to market sources, OPEC under the leadership of Saudi Arabia is playing the waiting game - ensuring the bankruptcy of the fracking sector, facilitating price stabilization above the current level would enable Saudi Arabia to become the no 1 oil producer again.
The market expects fracking operators to default on an estimated $200 billion of borrowings (secured through bonds). Evidence suggests the existing shale gas reserves are not as expected. As per reports by the Post Carbon Institute (a not-for-profit think-tank in the US), “reserves are likely to peak and fall off rapidly, far sooner than the industry’s backers predict”.
Drilling costs are moving upwards as deposits have to be found in inaccessible terrains.
Effects of speculations on oil price volatility
Traditionally, it was believed that oil price fluctuations reflect the external supply shocks. However, economists now believe, any changes in global oil prices also reflect the international economic conditions. Extensive research work on the subject has confirmed that global flow supply shocks have lesser impact on oil prices movements in comparison to global demand shocks.
Now, a question that needs to be answered is: can the flow oil production/demand alone influence the real oil price? If one considers oil storage (above/below ground) to be expensive then the answer to the question would have been yes, since the oil prices would be influenced by existing demand/supply conditions alone. However, it is not difficult to store oil, and therefore, oil inventory is another factor that determines oil pricing. A key factor being modifications in demand for inventories due to speculation – any changes due to expectation of price changes in the future.
In other words, speculation denotes the futuristic approach of economic stakeholders managing inventories emphasizing on streamlining oil consumption and production expeditiously - monitoring the projected path of the oil price. Again, under normal conditions, speculation would facilitate stabilization in oil prices in response to temporary demand/supply shocks. To conclude, speculative demand signifies making modification to surface holdings of oil inventories in response to price changes on the basis of information pertaining to future market scenario.
In the recent past, the emergence of commodity derivatives as an asset class has resulted in destabilising speculation. Therefore, inventory demand has been affected by modifications in oil futures prices that are not always based on information related to future oil market fundamentals. In other words, oil futures prices have reflected noise trading. Extensive studies on the issue have concluded “speculative demand shocks in the crude oil market increases/decreases the actual oil price by 10 to 35 %, thereby creating short run oil price volatility.”
The oil prices have fallen from $100 to $50 and staying at that level. Therefore, the moot point is, would $50 be the bottom limit or top limit of the new trading range. According to industry experts, $50 would be the bottom of the range and they expect oil prices to increase to $70 in the short run. But, trends in the past would suggest $50 to be the upper limit and oil prices could fall to $20.
According to the Secretary General of OPEC - Abdullah Al-Badri, the prices are expected to bounce back in the near future provided the sector persists with a 2 point strategy - continues to make capital investments while retaining skilled expertise.
The excess supply of oil has been the catchphrase in the recent past, but what would be the long term trend - say after 20 years?
According to BP’s long term projection, the demand for energy would increase by 41% (2035), while 95% of the demand would be from emerging economies – with China being the largest importer of energy in the next 20 years.
BP also said “20 years from now, though China would be the largest importer of oil, its rate of growth would have reduced significantly and it would be overtaken by India”.
According to an internal report from Exxon Mobil: The dominant nations to watch for in terms of demand for energy by 2040 are
• South Africa
• Saudi Arabia
BP predicts North America would account for 70% of shale output in 2035 in comparison to 99% of shale output by 2016. China followed by Argentina, France and Spain among others are expected to make significant growth in the shale sector.
The head of commodities strategy at BNP Paribas, Harry Tchilinguirian felt, “the other nations would not find it easy to replicate the shale oil success in the US. One of the most critical factors in the development of U.S. shale oil has been property rights and in particular the ownership of the subsoil resource. In the U.S, this ownership is private, allowing for large scale leasing of land by independent oil companies for the purpose of exploration and development. If there is going to be any development of shale oil reserves in China, it will likely have to be driven by China's oil companies rather than foreign participation, be it directly or through joint ventures”.
He further added, "A large number of Oil Company stocks have been disproportionately hit by the recent decline in oil prices, making the energy sector look undervalued".
Faith Bitol, Chief Economist at the IEA opined "Safety is the dominant concern - safety in plant operation, safe radioactive waste disposal and safeguards against the proliferation of nuclear weapons, and perhaps most importantly, there is the need to improve confidence in the competence and independence of regulatory oversight".
According to the International Energy Agency (IEA) energy investment outlook report - mid 2014, it is vital to tap new sources of funds (growth of bond, securitization and equity markets, along with securing mega funds from institutional investors - pension funds and insurers.
The IEA has reported energy prices would continue to move upwards in the long term if there is no change in energy policies. It predicts crude oil would be around $100 over the next 2 decades and above $200 per barrel (2030) in nominal terms. Though oil and natural gas are estimated to meet global energy demands for over 40 years at current consumption rates, the report felt rising demand globally would outperform production.
The cost of meeting the global energy demand is predicted to be $26.3 trillion in the course of 2030 – an average of over $1 trillion a year. Again, a majority of the oil fields are located offshore or smaller in comparison, thereby making the oil extraction more difficult. The demand for oil is forecasted to increase from the existing 85 million barrels per day to 106 million barrels per day in 2030.
China, India along with other nations that are not a part of the Organisation for Economic Cooperation and Development, would account for 87% of the increase in energy demand. The executive director of IEA - Nobuo Tanaka stated "While market imbalances will feed volatility, the era of cheap oil is over".