October 16, 2014
Oil prices surprise us again as Brent falls to below USD 90 on Thursday (9/10). What is going to happen next? Will the downward trend continue? Or should we rather expect the prices to hit USD 100 and above again? The answer depends on the time frame of expectations. In the short-term perspective, three sources of uncertainty may be distinguished. First, there are the geopolitical factors which have caused oil production in six North African and Middle Eastern countries to decline by a total of 3.5 million barrels a day, resulting in an escalation of tensions on the global oil market, which has been historically dependent on Saudi Arabia’s sizeable crude reserves – a bulwark against sudden price upswings. There are many indications that the production slump has reached its lowest point. The possibility of these missing barrels of oil returning to the market produces a price decline risk. The word ‘risk’ is used, because whether production in the region will continue to rise or not remains a major source of uncertainty. When I discussed oil prices a month ago, there were few reasons to believe that Libya’s crude production would go up. As it did, rising to some 900,000 barrels a day at present, the unexpected upsurge in oil supply of more than 500,000 barrels a day reversed the upward price pressure triggered by the Islamic State’s offensive in northern Iraq. However, considering the precarious political situation in Libya, the country’s oil production can fluctuate widely and is unlikely to increase any further.
Interestingly, IHS reports that the Central Bank of Libya currently has all of oil production and oil terminal staff on its payroll and is financing militia forces to protect vulnerable locations. With the central bank’s involvement, crude oil production and supply can be expected to continue uninterrupted over the short term. Although the turmoil and rioting in Libya persists, the unrest has been moved away from oil and gas infrastructure and city areas, which has further reduced the risk of production stoppages in the near future. In the long-term perspective however, the situation remains uncertain as the forces which will eventually gain control of the country may also attempt to take over its oil revenues. While the House of the Representatives, Libya’s democratically-elected and internationally-recognised government, has power in the east of the country, the west is governed by the General National Congress, which also controls Tripoli, where the central bank resides. For now, the central bank is willing to pay salaries to maintain oil supplies, but retains most of the revenue from selling the commodity in an attempt to forestall the conflict between the two rival governments. Currently, neither side is trying to take over all oil revenues, but the situation is bound to change some time. When one of the factions lays claim to the money, the country’s oil production may shrink significantly.
Libya is not the only country whose oil production has the potential to rise above expectations. Iran is still blocked by sanctions, which prevent some 1 million barrels of oil from reaching the market every day. As negotiations with the P5+1 (United States, Russia, China, Great Britain, France + Germany) continue, addressing the sanctions as one of many issues, the oil market is struggling with more uncertainty. This also applies to countries whose oil production has so far not suffered any long-lasting slumps on a scale which could materially affect the global oil market, such as Nigeria, Venezuela, Russia, and Iraq, the last country’s situation being the most worrying in the short-term perspective.
As for the sanctions imposed on Russia, they will likely have their toll on the global oil market in one or two years as the effects of stymied investment in oil production become apparent.
The second source of uncertainty has to do with how fast oil production is going to increase in the United States. The country’s rising oil production, along with the increasing supply from Saudi Arabia, Kuwait and the United Arab Emirates, more than offset the slump seen in North Africa and the Middle East, which has been instrumental in bringing relative stabilisation to the oil market. According to IHS, the potential increase in US oil production depends on whether the ban on American oil exports is lifted or not. The effects of the ban could be seen in the fourth quarter of last year, when the country’s market saw a steep decline in oil prices relative to Brent crude on the back of a seasonal decline in demand associated with repairs in American refineries. While unconventional oil extraction methods make drilling more and more wells necessary, low oil prices discourage any such investments. Lifting the ban on US oil exports could change the situation, as I argued in one of the previous posts.
Oil demand, which outside of the US has been growing at a slower rate than expected, will be the third factor of uncertainty in the coming years. What is uncertain in this case is economic growth in the Eurozone, which is facing the risk of deflation, and the condition of Asian economies, particularly China, which are grappling with an economic slowdown. The oil market is rapidly affected by stymied growth in the region due to still narrow refining margins. Russia and Brazil also contribute to the decline in crude oil demand.
However, there exist some concrete factors which will prevent crude oil prices from declining over the long term. Of these, production costs are the most important – if prices decline to a point where they are lower than production costs, oil production will be reduced, which will in turn cause the prices to go up again. A scenario where oil production declines due to low prices is particularly relevant in Saudi Arabia, where unconventional deposits account for a vast majority of the country’s reserves, and the United States, whose reserve potential is also unconventional in nature. While in Saudi Arabia the decision how much oil to produce is made arbitrarily (depending on economic factors), in the United States the same is based on individual decisions made by numerous independent entities, which are currently most affected by the oil export ban. This makes the US oil export policy, and any potential amendments to it, a crucial factor in shaping the situation on the American and global oil markets in the coming years.
Author : adamczyzewski