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The summer of 2008 saw the price of Brent crude rise to its record high, reaching more than $144 per barrel on July 3rd, and some speculated it would continue growing. However, the price fell to below $40 in late 2008, having shrank 77 per cent over just six months. Last year on June 19th, a barrel of Brent crude cost $115. This year on January 13th, it traded on the London commodity exchange for little more than $45 – the price had sunk 60 per cent over seven months. What is happening on the oil market?

Adjustment of expectations

Demand and supply in the oil industry are characteristically slow to react to price signals, lagging one or more quarters behind. As a result, anticipated demand and supply are more important than current prices, as it is these expectations that shape future prices, which can be secured using forward transactions.

Early last year, the global demand for crude oil in 2014 was projected to climb to 1.6 million barrels a day (mbd) and supply to 1.7 mbd. Prices were expected to decline marginally in these conditions. As it turned out half a year later, the echoes of the economic sanctions imposed on Russia reverberated more strongly across the Eurozone than originally anticipated. Worrying economic signs could also be seen in China, resulting in global growth forecasts being cut in the second half of the year and oil demand projections being revised downward as well. According to the most recent estimates, the demand for crude was up by a mere 0.7 mbd in 2014.

A different kind of surprise came mid-year, when Libya-sourced oil returned to the market and Iraq’s production prospects improved, prompting oil supply projections to be adjusted upward. As a result, there was 1.9 mbd more oil on the market than a year earlier, instead of the 1.7 mbd anticipated in early 2014.

With oil supply suddenly outstripping demand by 1 mbd, projections had to be revised and prices cut. There can be no doubt about the unexpected oversupply and the price slump. The question we should answer, however, is whether the low prices are a temporary phenomenon or maybe we are seeing a structural change bringing a permanent reduction of oil prices in the future.

I believe that the upstream sector’s technological revolution behind the US shale boom has caused a material adjustment of the oil pricing mechanism so that oil prices will now be more dependent on production costs rather than the budget needs of OPEC members. Since the marginal cost of producing a barrel of oil for which there is demand on the market is below the price needed to balance the budgets of most OPEC members (and Russia), the current market developments are a downward revision of future price trajectories in respect of projections made half a year earlier. In other words, the change looks permanent. We must bear in mind, however, that neither the technological revolution nor the shale boom will protect the world against geopolitical upheaval, which may drive up the price of oil. That being said, in the present circumstances the effects of any such events on the oil market will be less profound.

Flexible production

The OPEC cartel adheres to a policy of limited oil production (maintaining substantial reserves), which aims to keep oil prices at a level balancing the budget needs of key OPEC members (USD 100 per barrel on average). This level is substantially higher than the marginal cost of producing oil or tapping oil reserves in Saudi Arabia. It is also higher than the cost of tight oil production in the US, allowing the production to grow dynamically.

The process of extracting oil from unconventional deposits is characterised by a significantly diffused production potential. Several dozen thousand new wells are drilled in the US each year by thousands of small and large companies. Drilling enough new wells is critical to sustaining production, as 80% of oil will come within the first two years of production from a well. It should also be remembered that the cost of individual wells may differ, as may their productivity. Some yield below 100 barrels a day, others 800 and more. It is estimated that more than 70% of a typical well’s cost is financed using credit facilities, which is why future production has to be insured against the risk of falling oil prices. Because of this diverse structure and organisation of unconventional oil production in the US, the cost of producing a barrel of oil oscillates widely and the production business is highly sensitive to changes in crude oil prices (the process of change is virtually unbroken). When the price of oil slumps significantly, oil producers are not only pushed up against the profitability barrier, but they also face the limits of their ability to obtain external financing. As a result, fewer wells are drilled and production falters.

When on February 27th OPEC resolved not to slash production in order to buoy prices, the decision was taken with the specific character of the American oil production market, where production potential reacts rapidly to changing oil prices, in mind. What stood in the way was the divergence of interests within OPEC – the countries making a comeback to the market (Libya, Iraq and Iran) want to sell their growing output for an appropriately high price, while Saudi Arabia, sitting on top of crude oil reserves, hopes that low oil prices, which are bound to rise one day, will only do so after killing costly production projects (including some of American production), which gives an advantage to Saudi Arabia, affording it a larger share of the global oil supply pie.

Although the low oil prices (less than $50 per barrel) we are seeing today are not sustainable over the medium term, they may last for some time (one or two years), because the current oversupply (which has overtaken the anticipated annual demand growth) will not be absorbed immediately and the negative consequences of limiting investment in production will likely not become apparent earlier than after a year. Therefore, it is difficult to predict today how the prices will change over the long term, but they can be expected to be lower than we thought just six months before.



Author :
EurActiv Network