Every one is interested to get an answer to the trillion dollar question of where the oil prices are heading. The crude oil prices have fallen below $30 per barrel in early February and it was looking as though the prophesies of oil falling below $20 per barrel by some experts may come true.
However, some started to predict that $30 per barrel is the bottom and they will bounce back. But do even the best oil pundits know if and when oil price will reach the bottom, how long will it stay around that, when will they bounce back and to what level?
In 1986, oil prices fell below $10 a barrel when Saudi Arabia started to sell oil on a netback basis to increase its production. At that time, the world oil demand had fallen dramatically as a result of expensive fuel oil being replaced by cheaper coal. The Saudi oil production had fallen to uncomfortable level below 3 mmbd (million barrels per day) when their production capacity was above 9 mmbd.
In 2008, oil prices fell not because of unmanageable supply/demand imbalance. It was mostly because of economic recession and the futures market driven by speculation. However, prices recovered quickly since the oil surplus capacity was limited and demand was still increasing.
It is not easy to fathom the reason for the current fall in crude oil price. The Organisation of the Petroleum Exporting Countries (OPEC) surplus of around 3 mmbd (millions barrels per day) was easily manageable. Most of it was in Saudi Arabia which was producing at 80 per cent of its capacity and in Iran which was limited by the nuclear sanctions. Saudi’s policy to maintain its share might have been influenced to maximise revenues in the long run or to maintain geopolitical power.
History will show that Saudi committed an error of monumental dimensions by opening its production tap this time. Saudis have incurred dramatic loss in oil revenues amounting to billions as a result of oil prices falling below $30. They will never be able to recover even by maintaining or increasing their share of production. With global warming being high on the international agenda, there is a great pressure to reduce consumption of fossil fuels. The new energy era of switching to renewables has already started according to the International Energy Agency (IEA).
The US oil production has increased by 4.6 mmbd because of shale revolution in the last four years. That itself was able to absorb the increase in the world oil demand. Unlike in 1986, just by reducing its production by a small amount, Saudi by itself or with the help of other OPEC countries, could have easily avoided any imbalance in supply and demand. For geopolitical reasons of producing financial problems to Iran and Russia, it might have opened the tap.
According to a study done before the recent oil price fall by Morgan Stanley Commodity research, the average cost of oil production varied from $27 per barrel for onshore Middle East to $70 for oil sand. Given such high average costs, $30 is not sustainable.
As a result of competitive forces on oil service providers and also improved efficiency on the part of oil companies, these average costs have come down. Still they are far above $30. There are other studies also collaborating high cost of crude oil production. According to Wood Mackenzie (well known oil consulting company) 6 per cent of world oil production (about 5 mmbd which can eliminate surplus) cannot recover cash cost at $30 per barrel.
Cost of production
Because of marginal cost of oil production around $60 per barrel, most pundits predict that even when prices increase from the unsustainable level they will not climb back to $100. Some of them even predict that they are likely to remain below $70 to $80. Such predictions might have been influenced by the current popular peak demand theory.
It has always been fashionable to discuss the death of OPEC whenever oil prices were falling. The same is true today. Unlike other cartels, OPEC has been rising like phoenix each time. But for OPEC, oil prices would not have remained above $100 per barrel for four years in recent past.
Though Indonesia is not an oil exporter, it has rejoined OPEC in December, 2015. During the times of oil prices falling in the 80s, other major non oil exporters like Norway, Russia, and even Texas had showed interest in collaborating with the OPEC to stabilise prices.
Historically, oil pricing was always controlled either by collusion by oil companies (famous seven sisters controlling international oil till the formation of OPEC) or Texas Railroad commission or by OPEC. Thus, it is too early to announce the death of OPEC.
It is more than likely that the oil supply/demand will reach balance by the end of 2016. In the US, oil production has already started to fall. Active drilling rigs count shows dramatic drop which will result in lower production. The IEA is predicting lower world oil production of about 0.6 mmbd and demand increase of 1.2 mmbd. Despite the current war like relationship between two OPEC producers (Saudi Arabia and Iran), the OPEC led by Saudis will finally realise that not limiting production is against their collective good.
When better balance is reached, prices will go above $50 per barrel to $60. But going above $100 is unlikely any time soon. Of course all bets are off if there is any geopolitical event disrupting oil production. The NDA government has done the right thing by increasing taxes on petrol and diesel. However, on the oil subsidy front, they need to move fast and liberalise the LPG market. The poor can always be helped better by giving direct subsidy through foolproof Aadhaar.
