Oil Price: Heading for Further Lows – Or Will the Super-Cycle Continue?

RelevanceTen years ago today Brent closed at an historic low of $9.64/bbl. At the time, most in the industry expected the oil price to fall further – indeed The Economist called for $5/bbl oil. Given the recent precipitous collapse in oil price, industry executives, investors and observers are again asking whether we are now in the throes of a bust in the usual boom-bust cycle, or if a return to rising prices is possible over the medium term. The next year or so promises lower prices (and falling) with the prospect of a return to $100/bbl oil minimal. In the medium term, much will depend on the rate of large, new discoveries. Absent these, then the next period of strong, global economic growth is likely to be met with strained supplies once again, and therefore a return to high prices.

AnalysisMost industry observers have been taken aback by the speed of the recent decline in oil price. In the summer oil stood at over $140/bbl – today’s price is nearer $40/bbl. Other commodities have fallen in line with oil. The question on everyone’s lips is whether this decline is evidence of a bust in the historic boom-bust cycle of oil price, or whether it is simply a temporary “blip” in an unstoppable rise in prices, labeled by some the “super-cycle”.

The severity of the oil price fall has taken many by surprise, including oil industry executives and traders. In fact it was just a few months ago that the head of Gazprom predicted $250/bbl oil. Most within the industry and the investment community see the current fall as a temporary set back, a market correction that once made will see a return to higher prices. However, two authoritative reports released recently question the conventional wisdom and predict that the oil price is set for a long period of relative weakness.

The World Bank recently issued a report claiming that the commodities boom was over, and the U.S. Department of Energy is predicting global falls in oil demand in 2008 and 2009.

Those who predict higher oil prices over the medium to long term cite the following in support of their argument:

  1. Strong demand continuing in emerging economies over time.
  2. Supply constraints due to under investment over the last 20+ years and a continuing fall in non-OPEC production (e.g. Russia).
  3. Supply constraints due to lack of finance for projects during the credit crunch and a lower appetite for investment during this period of relatively low prices.
  4. Supply constraints as production falls in rapidly maturing regions (such as the North Sea).
  5. The rise in resource nationalism slowing the pace of oil exploitation (either deliberately of because local NOCs are not well enough equipped to increase supplies in a timely fashion).

Those predicting lower prices in the medium to long term use the following arguments:

  1. The major consuming regions (U.S., Europe and Japan) are in recession, and economic growth in emerging economies is significantly lower (China’s growth forecast was recently reduced from 10% to 6%). The prognosis for growth over the medium term is thought by many to be poor.
  2. Slower than predicted growth in population and in incomes will reduce economic growth.
  3. The strengthening dollar is reducing oil demand in non-Dollar countries.
  4. The severity and duration of the oil price rise in 2008 has led to an increased political and consumer will to conserve and to find substitutes (either other energy sources or non-OPEC oil) that is irreversible. Many initiatives have already been put in place to this effect during recent years of high oil prices.
  5. The change in administration in the U.S. will lead to increased focus on environmental issues and policies that reduce hydrocarbon consumption.
  6. A strengthening dollar reduces the cost of supply, encouraging increased production.
  7. A strengthening dollar encourages OPEC to have relatively higher quotas (as oil is more expensive for non-Dollar consumers).
  8. Any increases in demand will easily be absorbed by current excess supply capacity. Capacity has been growing due to OPEC quota cutbacks and investment in new oil fields when the oil price was high.
  9. The cohesion of the OPEC cartel is questionable. OPEC initiated a 1.5 million b/d production cut from 1 November, but many of its members will be tempted to cheat the system by producing above quota – member countries will have experienced a dramatic reduction in oil revenues at a time when much of the world’s economy is suffering the effects of the financial crises. Another risk is that OPEC underestimates (as it did in 1998 and 2001) the severity of the economic downturn and is not aggressive enough in its production cuts.
  10. During the period of high oil prices investments were made in new technology to reduce the cost of nonconventional oil exploitation. Some of this technology will be deployed even in a lower oil price environment.
  11. Reduced fuel subsidies in developing countries.

Over the immediate short term though, most agree that the prospects for an oil price hike back to $140/bbl are low. Oil demand is falling in line with the credit crunch induced global recession. In fact, the drop in demand has been so severe that the oil market is in contango – a rare situation where current spot prices are lower than futures prices. Oil companies and traders are incentivized to hold oil in storage – waiting for higher prices. The risk here is that when the storage capacity runs out oil will be dumped on the market, depressing the spot price still further. The pressure on OPEC to reduce quotas further thus increases, at a time when the cartel can barely keep up with the pace and severity of an unexpected recession.

If oil prices are set to be much lower (with increasing downward pressure) for the next year or so, what about over the medium term? Those predicting a return to $100/bbl oil will probably be disappointed over the next couple of years. A key statistic that I will watch is the number of large discoveries made each year. This has been declining steadily for some time now and if this continues it will indicate that the world truly is “running out of oil” and that the next period of demand growth will be met with severely stretched supplies (and therefore a return to very high prices).

11 December 2008

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