Will low oil prices continue to rule?

As the international oil industry says, it is only the foolish or the genius who dare to forecast oil prices.

Ever since the drop of Brent crude oil price from a high of $110 per barrel in June of 2014, to a floor price of $45/b this January, billion dollar question is what will happen to the oil prices. Despite the earlier failure to predict oil prices, oil experts are never shy to predict oil prices. While some are predicting the prices to fall to $40/b level, there are pundits who claim it will go above $70/b. Common person may get the impression that the oil experts can really forecast how the oil prices will behave. Can they?

When Brent was above $100/b at the end of 2013, most experts predicted only a small drop of $2 to $5 from the 2013 price of $109/b.  There were some experts - though very few- predicted more than $10 to $20 per barrel. Not more than a few had anticipated a drop like the one in 2009 when Brent had fallen below $50.

Just like the current fall in crude oil prices, in 2008, after reaching a high of $145/b, oil fell to $38/b.  However, it did not remain at that floor level for long. It took less than a year for it to reach a level of $75/b. After fluctuating at that level for few months, it started to increase again. After reaching $110/b it fluctuated around $100/ b for three more years to fall below $50/b this year.   

At the time of the 2008 crude price fall, the OPEC surplus capacity was above 5 million barrels per day (mmbd). According to an International Energy Agency estimate, the current OPEC surplus capacity is about 5.3 mmbd. Most of it is controlled by Saudi Arabia. All others with the exception of Iran are producing close to their maximum capacity.  

The IEA forecasts the world demand to increase by about 1.4 mmbd in 2015 and non-OPEC supply to increase by 1.0 mmbd. Non-OPEC supply has already been reduced to reflect the drop in oil price. The resulting demand for OPEC oil will be around 29.4 mmbd whereas OPEC has the capacity to produce 34.7 MMBD. Given the adequate surplus supply capacity, it is easy to argue that prices are unlikely to stabilise over $50/b even though price has gone above $65/b.

In my view, it is not possible to predict whether crude oil prices will bounce back as happened recently during 2008-2014 or follow the pricing development after crude oil prices collapsed from $36 lower prices (market has yet to decide) in 1986. It took over 18 years for prices to come to the level prevailing before the price collapse.

This is because oil is a political commodity. The usual supply/demand economics does not control the prices. Factors affecting oil prices are difficult to predict. In addition, speculation on futures market has only worsened the pricing scenario.

An analysis of marginal cost for oil production for different types of oil (OPEC vs Non-OPEC, conventional vs non conventional, onshore vs offshore, shale oil in the US etc) show that there will be enough production to meet the demand even below $40/b. A 2013 study done by London based Centre for Global Energy studies had showed that 30 per cent of the world production has less than $10/b marginal cost and 90 per cent of the world oil production has less than $20/b of marginal cost.

Another oil consultant Wood Mackenzie based on a study of 2,222 oil fields has shown that less than 1.6 per cent of the oil production will be unprofitable at current crude oil prices.  These marginal costs do show that world can manage to muddle through for few more years and remain around $50/b or even below that level.

Surplus supply capacity

On the other hand, surplus supply capacity is not all that significant and more than 80 per cent is controlled by Saudi Arabia. The avowed goal of Saudis to control supply is to pressurise costly oil producers to give up their projects to ensure higher market share for them.

However, there are some who attribute Saudi’s willingness to allow prices to collapse was to put economic pressure on the fragile economies of Russia and Iran to bring them to mainstream politics. There is also a possibility that Saudis might have adapted lower oil price policy to comply with the US request. 

Ever since the Iranian nuclear agreement, there is every possibility that Iran will be able to export more crude oil. This will further increase OPEC surplus capacity. Even with the US shale oil development being negatively impacted and non-OPEC production showing no increase, one can argue that oil production will exceed oil demand resulting in soft oil market.  

However, it is quite possible that the geopolitics of oil could change quickly and for reasons which we cannot foresee today. History has showed how oil pundits have not been successful in predicting such oil disruptions.

As is often whispered in the international oil industry, it is only the foolish or the genius who dare to forecast oil prices. It is not often one comes across the latter.