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The London petroleum exchange saw the price of Brent crude slide to just under USD 70 per barrel today. What is more, after last week’s decision by OPEC, there is no indication that the downward trend will reverse any time soon. Oil prices are at their lowest since 2008. Although I explained the reasons behind the trend in a previous entry (http://napedzamyprzyszlosc.pl/en/blog/uncertain-times), the matter generates so much interest that I have decided to supply a brief commentary (organised in bullet points) on the situation in the oil market in the wake of OPEC’s decision.

1)     Ample oil supply has overtaken demand. The price is bound to fall and adjust to the new conditions.

2)     There are two reasons for the increased supply of crude.

a)     The first reason, US tight oil, is certain. Since 2008, the amount of crude oil supplied from this source has risen by more than 3.6 million barrels a day, offsetting the decline in supply seen in the MENA countries (some 4 million barrels a day within the same time period). Were it not for tight oil, the price of crude would be much higher. It should be noted that this is not only about production increase (currently at about 1 million barrels a day), but also about room for growth (oil producers scattered across the U.S. are highly sensitive to prices – when these approach their production costs, which may vary greatly from basin to basin, they cut back on drilling).

b)    The second reason is an unexpected one. Oil production in Libya, where two factions are now fighting for power, has suddenly risen to above 900,000 barrels a day, while the expected figure was no more than 400,000 barrels. The supply spike accounted for half of the expected global crude oil demand increase (1.1 million barrels a day).

c)     Oil sourced from Iran (still burdened by sanctions), Iraq (production growing) and South America, which are all members of OPEC, is expected to enter the market soon.

3)     The increase in supply coincides with a global economic downturn, with China’s slowing economy being a major contributing factor. As a consequence, demand for crude is shrinking. The IEA has recently cut its oil demand growth forecasts for 2014 and 2015 by 200,000 to 300,000 barrels a day.

4)     All these factors contribute to the decline in crude oil prices. Will the downtrend continue? And how deep could it be?

a)     The situation in Libya and Iraq remains volatile, talks with Iran are not going as planned, while Russia is up against the wall. This may result in a sudden, actual or threatened, withdrawal of several hundred thousand barrels of oil a day from the market. Should this happen, the price of oil is likely to go up. The markets are keeping a close watch.

b)    For the time being, however, the price continues its downward march, straining the production cost barrier.

c)     Just as we predicted, OPEC did not cut production because:

i)      It is difficult to reconcile the interests of those countries which have lost their place on the market and are now making a quick comeback with the interests of those for whom high oil prices are what they want.

ii)     If OPEC had cut production, the price of crude oil would have gone up, driving oil production in the U.S. up and increasing pressure to lower prices. The move to limit production would benefit American oil companies.

iii)    As some expected OPEC to trim prices, when it eventually decided not to do so, the price dropped and is now trying to find a production cost floor (not only in the U.S., but all eyes are on the U.S.).

d)    How far can the price fall? It is difficult to say, because there are financial players on the market, who, naturally, look at the fundamentals, but react excessively and amplify their effect. This means that in the near term (one, two or three months, maybe two quarters), we may see some really low crude oil prices. As low prices put a damper on oil production in the U.S., the price will rebound on reduced output. From what floor, it is hard to predict.

e)     What is important is that low oil prices, even at the levels we are seeing today, will have an effect on crude supply in the years to come. With upstream investment curbed, supply will shrink more than what is expected today, putting upward pressure on oil prices (long-term, rather than short-term, as upstream investments take years before yielding results).

5)     What about fuel prices? Sudden changes in crude oil prices do not immediately feed through into fuel prices for several reasons – their duration is uncertain, past price levels are more important (i.e. whether a decline is a correction after a period of growth or a continuation of a downward trend). The first effect of the current price declines will be an increase in refining margins, which will quickly improve production profitability – fuel production will go up, higher capacity utilisation in refineries will bring down unit costs, opening way to increased production and, consequently, lower fuel prices. But how low can they get? It is difficult to say, but in all likelihood refiners will be fighting for their share in the market, which will drive market prices down. The wholesale and retail prices will follow.

6)      Lower crude oil prices translate into lower energy costs, stoking consumer demand and boosting disposable incomes left after all energy bills have been paid. While lower prices will promote growth in oil- and fuel-importing countries, they will have an opposite effect on oil exporters − oil-rich countries often subsidise the cost of fuel, which means that lower oil prices have weak or no transmission in the market, but at the same time cause budget revenues and spending to shrink

 

 

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