Feature Stories | Jul 03 2015
This article was first published for subscribers on June 24 and is now open for general readership.
By Greg Peel
The speed of the plunge in crude prices, beginning last year, took the world by surprise, even though in retrospect it all made sense. It was obvious US shale oil production was growing rapidly, but no one had quite predicted just how rapidly. That Saudi Arabia should decide not to continue to play global supporter of the oil price, via typical production cuts, given the US was the perpetrator of excess supply, seemed logical. Yet most still expected the Saudis would cut, because they always had done so in the past.
Adding together the surprises led analysts to suggest, earlier this year, that US$45 oil actually made sense. Indeed, while short-term snap-back rallies were likely, medium term oil was more likely to fall into the thirties than it was to recover into the sixties, they argued. But rather than despair over low oil prices, the world should embrace the boost they would obviously provide the global economy, just at a time one was needed.
Two further surprises thus awaited. The first is that we now have oil back in the sixties, belying widespread bearish assumptions. The second is that low oil prices don’t really seem to have provided much of a boost to the world’s major economies, such as the US and China, to date.
Having rebounded this far, what might we expect the oil price trajectory to be from here? Might we ever see triple digits again?
Missing Consumer
The analysts at GaveKal were among those assuming, back when oil troughed at US$45/bbl, that US$50/bbl would prove more of a ceiling than a floor for the (Brent) crude price going forward. Oil back at US$65/bbl thus came as a surprise to GaveKal, but the analysts have not altered their general thesis:
“We are inclined to stick to our bearish view on oil for a while longer, and even more forcefully to our conviction that global economic activity will benefit strongly from cheap oil in the second half of this year”.
As far as the global economy is concerned, the difference between US$45 and US$65 oil is by the by, GaveKal argues. What matters is that both prices are a long way below the US$100-110 prices prevailing a year ago. Even at US$65, the analysts calculate, the oil-consuming sectors of the global economy will enjoy a US$1.3trn boost from the price differential. Given the usual lags between income and spending, it will only be in the second half of this year that the analysts see the main impact on demand.
In the second half of last year, as oil prices tumbled, many analysts assumed at the time that US consumer spending would see a big jump as early as the March quarter this year, and that lower oil prices would prove the ideal medicine to turn China’s slowing growth around. But in the March quarter, the US GDP contracted 0.7% and China’s GDP growth slowed to 7.0% from 7.4% in 2014.
Those analysts were not necessarily off the mark, just premature.
Demand Response
The other, logical, assumption one might make is that lower oil prices boost global demand for oil. According to the Saudi oil minister, this is exactly what has happened, and is the reason why prices are back over US$60/bbl, which the Saudis can draw upon to justify their decision to not cut OPEC quotas. Behind this argument is the assumption that the trends towards oil conservation and alternative fuel substitution that were driven in previous years by oil prices as high as US$100/bbl are now reversing.
But both these mechanisms work much too slowly, GaveKal suggests, to have had any perceptible effect so far. Conservation and substitution do not happen overnight. And claims of increased global demand for oil do not correlate with slower GDP growth in the US and China.
A more plausible explanation for why oil prices have rebounded so strongly is China’s decision to increase its strategic reserves – something Beijing is always inclined to do in any imported commodity when prices fall to much cheaper levels. Economic activity and industrial production plunged in China in the March quarter, yet oil imports soared to record levels.
Strategic stockpile building is only a temporary phenomenon, and already Chinese oil import growth is reversing, leaving excess supply again the dominant force in the market, GaveKal notes.
Supply Reduction
Another explanation, and indeed arguably the prime focus of oil futures market speculators, is the ongoing reduction in US and Canadian supply. While it cannot be argued that falling supply induces rising prices, the longer term problem with the argument is that North American supply reductions have been driven by high-cost producers who require higher oil prices to be economical. The Catch-22 is that while many were uneconomical at US$45, at US$65 they are back in the black. The longer the oil price holds up at current levels, the more supply reduction will slow, and reverse, suggests GaveKal.
National Bank analysts note the US rig count has fallen 60% since December, which would go a long way to explaining the crude price rebound. Yet as prices rebounded in May, US production spiked to the highest weekly rate since the 1970s. This suggests to NAB there is still plenty of latent production capacity in the US which can respond very quickly to price changes.
Furthermore, not only has Saudi Arabia not cut its own production, it has increased production in an attempt to stave off falling export market share. Add in Iran, where the lifting of sanctions will allow for a return to previous export levels, and Iraq, where oil production is slowly returning to levels of days gone by, and production cuts in North America become less and less significant.
Geopolitics
Indeed, GaveKal notes that four of the world’s geopolitical hotspots – Iran, Iraq, Libya and Nigeria – together produced two million barrels more per day in 2012 than they did in 2014. A return to such production levels would therefore not require any new wells or infrastructure.
Geopolitics is, of course, always a spectre hanging over oil markets, and the reason why many still believe oil can always rush back to US$100/bbl if tensions flare. Certainly, when oil was over US$100 last year, a significant geopolitical premium was included in the price.
But realistically, those warning of geopolitical influences have been defeated by their own argument. Last year, the oil price hung in the air even as global supply grew and grew, until eventually something had to give. And as GaveKal suggests, just how much worse do we need geopolitics to be to bounce oil back up another forty dollars? If anything, tensions are more severe now than they were a year ago.
We now have Libya devoid of effective government and beholden to warring tribes, Syria and Iraq overrun by IS, Nigeria under constant attack from Boko Haram, Yemen under attack from Houthis, Iran still under Western sanctions and Russia now under Western sanctions. Sure, it could still get worse, but it is already worse than it was a year ago.
Unsold Cargoes
In about a month’s time, US oil refineries will be running at peak as they cater for increased fuel demand driven by the summer driving season. A month in advance, refinery demand for crude should thus peak. But as Morgan Stanley notes, instead of securing contracted supply, US refiners are simply sourcing barrels in the spot market in order to capitalise on oversupply.
Just how much oversupply?
Floating storage – holding oil inventories in tankers rather than in land-based facilities – is not yet economical, Morgan Stanley notes, but reports suggest some ten million barrels of mostly Nigerian crude is currently sitting off the coast of West Africa. As many as seven super-tankers of North Sea crude are waiting off the coast of Britain. Some cargoes are taking more than three months to find buyers.
This is the state of play at a time northern refineries should be running at peak as seasonal gasoline demand peaks. Morgan Stanley is somewhat worried what will happen to the oil price once seasonal demand falls off again. Add in the chance of new supply from Libya and Iran, and “a more range-bound (if not lower), yet volatile, oil price environment seems increasingly likely in the second half of 2015,” the analysts suggest.
And as Deutsche Bank’s analysts note, not only does seasonal demand drop off in the US autumn but refineries typically take the opportunity to shut down for maintenance at that time, which in 2015 will leave extensive crude inventories gathering dust.
That said, there is sufficient supply tightness in the US right at the moment, Morgan Stanley notes, to encourage the import of lower-priced Atlantic crude. But that supply tightness simply reflects a temporary loss of supply from Canada due to upgrade maintenance and the impact of wildfires, as was the case in 2013. Morgan Stanley is worried those Atlantic cargoes are going to arrive just as Canadian production ramps back up to normal levels.
Is OPEC Dead?
As noted earlier, the world was taken by surprise last December when OPEC decided not to cut production quotas in the face of falling oil prices, just as it had always done for decades. Saudi Arabia is OPEC’s largest producer by an order of magnitude, and its decision to abandon its traditional role of global swing producer and suddenly shift to a strategy of maximising market share left oil markets rather shocked.
Citi is not so surprised.
In the autumn of 2013, Saudi Arabia was exporting around 7.2 million barrels per day of its 9.5mbpd production, Citi notes. The US took around 1.6mbpd of those exports and China around 1.2mpbd.
By mid-2014, US imports of Saudi oil had fallen to 1.0mbpd, thanks to the shale revolution. This meant that in order not to lose market share in the US, the Saudis were forced to sell crude at lower prices to the US than it was to Europe and Asia. Thus not only were the Saudis not attacking lower oil prices with typical production cuts, they were driving oil prices even lower.
The Saudis took such an about-face in strategy because supply growth in the US was beginning to alarm them, Citi suggests. Shale is responsible for a 90% increase in US domestic oil production since 2010. Over the same period, Canada has increased production by 40% thanks to tar sands, and Brazil has increased production by 25% thanks to deep water drilling.
Moreover, 2010 was the year of BP’s Deep Horizon oil spill in the Gulf of Mexico, which at the time stalled Gulf production growth due a drilling moratorium. Gulf production is now returning to previous levels, Citi notes.
By mid-2014, Saudi crude exports to China had fallen to around 0.8mbpd. If it was concerning enough to the Saudis that China’s economic growth rate had fallen to 7% from previous double digits, it was alarming that Beijing’s attempts to shift China’s economy from one of industrialisation and urbanisation-driven to consumer-driven had greatly reduced the energy intensity of the economy.
Up until 2010, China’s demand for diesel had been growing at roughly the same rate as GDP, Citi notes. But in 2011, diesel demand slowed to only 5% growth. In 2014, it contracted.
“Thus on both the supply and demand side,” says Citi, “the Saudis concluded that they were confronting a long term threat to their ability to manage markets and, more critically, maintaining their market share, which is key to monetising their extremely long position as the holder of huge oil and gas reserves”.
It was also not lost on the Saudis, in making the decision not to cut production, that US shale had produced a global glut in lighter, sweeter (low sulphur) crude, when Saudi oil is heavier and more sour (high sulphur). Cutting heavy, sour production would still leave a global glut in light, sweet supply, and thus would have little effect.
Furthermore, Citi notes, the Saudis would have been aware that it was rather unlikely that were they to reduce OPEC production quotas, other OPEC countries would ignore them. Iraq was in the process of trying to recover its lost production, and thus export profits, Iran was not about to cut its production just as Western sanctions were lifted, and with no one clearly in charge, Libya would have just kept pumping.
Hence Saudi Arabia decided to throw decades of swing producer status and just go for market share, at whatever the price, lest it be lost forever.
And thus Citi believes oil prices will be lower for longer.
GaveKal concludes that none of the fundamental explanations for the rebound in oil prices is very convincing. In “normal” competitive markets, prices are set by the cost of production of the highest-cost producers, the analysts note. In the case of oil at present, these are the US shale oil producers. Their marginal cost of production appears to be currently in the US$50-60/bbl range but is falling as the cost of drilling continues to fall.
That is why GaveKal expects US$50-60/bbl to prove a ceiling for prices, and not a floor.
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