The oil price evolution: present and future?

The oil price evolution: present and future?

Executive Summary

In 2008, when the oil price exceeded $100/barrel for the first time, everybody expected it to keep rising inexorably due to the supposed peak oil phenomenon. And it did so on average – notwithstanding the 2008 financial crisis accident – until it reached $111.8/barrel at the Brent Index in June 2014. Then suddenly, between June 2014 and January 2015, the oil barrel lost 57% of its value, falling at $47.76 (Brent Index). This sharp decline is due to an oil glut triggered mainly by the tight oil revolution in the United States and to the subsequent decision of OPEC countries, and more specifically of Saudi Arabia, not to curb their production to sustain prices, thus abandoning their traditional role of swing producer in order to preserve their market share. Some countries heavily dependent on oil exports have been badly hit, as well as the oil companies whose costs of production were the highest. But instead of curbing current oil production, the Saudi strategy is likely to harm longer-term investment and the development of new fields, meaning that the oil price should stay low for a few years before rising again once demand will have caught up with supply.

____

Almost one and a half year after the price tumble of June 2014, oil is still relatively cheap today. The price of a barrel today is $52.65 on the Brent Index and $49.63 on the West Texan Intermediate Index. According to the International Energy Agency, it is therefore currently uneconomic to produce oil sands in Canada (average cost of $75/barrel), oil in Mexico ($72/barrel), tight oil in the United States (average cost of $67/barrel), deep-offshore oil in Brazil (average cost of $62/barrel), and oil in some non-OPEC countries. The global average cost of production for one barrel is currently $42.

The fall in price between June 2014 and the beginning of 2015 occurred because of a current oil glut. It is estimated that the total supply is currently higher by 3 to 4% than the total demand (around 2.6 million barrels per day[1]). What are the main reasons for this oil oversupply?

First, the tight oil revolution in the United States has allowed it to become the first world oil producer since 2013, with a production of 14.0 million barrels a day in 2014 according to the US Energy Information Administration (or of 11.6 million barrels a day according to BP). It has surpassed Saudi Arabia, which produces 11.5 million barrels a day[2] and Russia, whose production is 10.9 million barrels a day[3]. Even if the United States does not export oil yet, its imports have been drastically cut, which creates a lot of spare supply.

Besides, global primary energy consumption decelerated sharply in 2014. Global oil consumption growth was weaker than production growth. The growth in energy consumption due to emerging economies (China especially) accounts for all the global growth in energy consumption but was well below its 10-year average (+4.2%) in 2014 (+2.4%)[4]. And, at the same time, the OECD consumption experienced a larger than usual decline. This decline in energy consumption growth can be explained by a relatively weak economic activity in 2014 and lowered global economic growth expectations for 2015, increased energy efficiency and a growing switch away from oil to other energy sources.

Finally, contrary to what was expected by financial markets, turmoil in Iraq and Libya had hardly affected their productions in 2014, of almost 4 million barrels a day when combined[5].

In the face of this oil glut, OPEC decided in November 2014 not to cut its production quotas. The OPEC production amounts to about 40% of the total world production. Saudi Arabia especially, who provides 32% of the OPEC total production, refused to curb its production in order to support the prices – whereas it had traditionally done so as a swing producer. Saudi Arabia decided it preferred to maintain its market share, as it is able to sustain a price war in order to drive American tight oil producers out of the market. The Saudis are especially keen on retaining or increasing their market share in the booming Asian market (particularly in China and India). Saudi Arabia might also want to dispose of its huge oil reserves before it is too late, as it is hard to predict how the oil market will evolve in the coming decades in a context of adjustments to climate change. Lastly, the Saudis might not have been dissatisfied to harm the finances of Iran – their great foe – and of Russia – as their ally, the United States, may have wanted to exert more pressure on Russia in the wake of the annexation of Crimea in March 2014.

Low energy prices are always good news for the industry and transport sectors, therefore a fall in oil price is beneficial to every national economy. But for oil producing countries and companies, a prolonged low oil price can become very preoccupying.

Thus, many countries heavily dependent on oil exports have been hit hard by the sharp decline in price since June 2014, and at the forefront Russia, Venezuela and Iran. In Russia, where hydrocarbons represent up to 30% of the country’s GDP and half of its GDP growth since 2000[6], this sharp cut on exports revenue has added a new burden to the international sanctions imposed on Russia and the country has plunged into deep recession, with the economy expected to contract by 3.8% this year[7]. Venezuela, an OPEC member for which 95% of export revenue is made up of oil, has been trying since the end of 2014 to sign financial alliances with other countries, such as China, to stop the haemorrhage in the country’s economy. In the case of Iran, a low price of oil is very damaging for the regime as well. The country’s economy is heavily dependent on its oil revenues and Iran is currently paying to keep the Assad regime afloat in Syria, which is taking a toll on its finances as well. It put additional pressure on the Islamic Republic to hammer a nuclear deal with the P5+1, which was finalized and signed in July 2015. With the lifting of international sanctions, the country will now be able to resume free oil exports, which will give it a breath of oxygen. On a non-state organization level, the ISIS terrorist group which controls a part of the Iraqi production and sells it on the black market, has also seen its revenue decrease.

Regarding the oil producing companies, as always those involved in the riskiest projects have been hit the most badly. First, as intended by Saudi Arabia, the activity of quite a large number of American tight oil producers has become uneconomic. The United States producers have announced large cutbacks in their 2015 drilling and development programs. Frackers who had borrowed heavily on the expectation of continuing high prices have been forced out of business. But Western oil companies with high-cost projects involving drilling in deep water or in the Arctic, or dealing with maturing and increasingly expensive fields such as the North Sea fields, are also suffering and have put on hold a number of projects.

However, for those who can still afford to produce, their position is in a way strengthened. Before the fall in oil prices, two third of the drillers in the United States needed a barrel at $70 to break-even. As always, a crisis in the oil market brings about productivity gains – oil companies are forced to do as well with reduced economics means and they take advantage of the situation to cut many of the less useful jobs and to apply new technologies –, and lower costs of production – because fuel is cheaper for them too!–. Thus, it is now estimated they need a barrel at $60 to be economic (according to Wood Mackenzie, a global energy-consultancy group), or even at $30 in some fields (according to a Bloomberg Industries survey). And even though many producers are currently uneconomic, they have been bailed out for the past months by American hedge funds investing to support the industry. In this sense, the Saudis’ strategy might backfire on them in the long-run by increasing American tight oil producers’ efficiency and competitiveness.

From its part, Saudi Arabia can sustain this price war for a while. Its production cost is the lowest in the world, at around $22 per barrel. And even though around 80% of government revenue comes from oil exports and the state budget is balanced for a much higher expected oil price (its fiscal breakeven oil price is estimated between$90 and $100 by the IMF for 2014 and 2015), Saudi Arabia can draw from its (approximately) $700 billion reserves, stored away when prices were higher.

Regarding other energy sources as well as CO₂ emissions, low oil prices are not especially good news but it is not all doom and gloom. It is bad news for energy efficiency, for the level of CO₂ emissions that is driven by a cheap oil, and for biofuels in Europe and America – which are not competitive anymore compared to oil – and hybrid and electric cars. But almost all other sources of renewable energy should not be affected by the drop in oil price as they are meant for electricity supply, and therefore are not in competition with oil. Finally, regarding natural gas, prices in Europe fell as well, as they are dependent on the oil price even if not fully correlated to it. So, gas producers are also badly hit. In the short-run, it is good for the planet as it makes gas, a very low carbon-emitting energy supposed to be driving the energy transition, more affordable but in the long-run it will slow down investments in new gas producing capacities.

The oil market weakness is likely to persist for several years. The oil price is likely to stay low or even sink further. Indeed, as prices are low, some countries like Russia, desperately need cash and therefore actually try to sell higher quantities to sustain their frail economies. Russia has increased its daily production by 1.3% year-on-year in January 2015 through July 2015[8], becoming in recent months the world’s largest producer. Overall, the drop in oil prices has not really affected the output from existing wells. And with the lifting of international sanctions, Iran will soon retrieve its former level of oil exports and contribute to the current oversupply. Moreover, as the oil price has been very low since August 2014, people have been stocking up[9]. But sooner than later, storage facilities will be full, the oversupply will then become even more pronounced and sellers will have to slash prices to sell off their oil.

However, many oil producers have become unprofitable since the price fall and therefore have gone out of activity or have stopped investing in exploration and in the development of new oil producing facilities. Without new investments if the price stays low, the oil production with the currently existing facilities will slow within a few years. The supply will then contract, the glut will be absorbed and the price will begin rising again. Economic expansion in Asia, especially China and India, will resume driving the oil market expansion. The global demand for oil is expected by BP to grow by an average of 0.8% a year until 2035[10]. By this year, it is expected that the United States will have become self-sufficient in oil and that China will have overtaken the United States as the biggest world oil consumer.

So, the impact of low oil prices today is now expected by the Saudis to have an impact on future oil production, rather than current production. This requires patience, but they hope that within a few years they will get the lion’s share of the market with high prices, once demand will have caught up with the current level of supply.

Camille MEYNARD
Membre du Comité Energies de l’ANAJ-IHEDN

____

[1] Reuters : oil supply/demand balance, Oct 14, 2015.
[2] US Energy Information Administration data.
[3] US Energy Information Administration data.
[4] BP Statistical Review of World Energy, June 2015.
[5] US Energy Information Administration data.
[6] American Enterprise Institute, The political economy of Russian oil and gas, May 29, 2013.
[7] Russia’s economy ministry, outlook for 2015
[8] Bloomberg View, Why Oil Producing Countries Keep on Pumping, L. Bershidsky, Aug 2015
[9] B. Bennett’s blog about energy
[10] BP Energy Outlook for 2035