We recently reviewed the crude oil market as it relates to the persistent battle between ‘conventional’ oil producers (like OPEC) and ‘unconventional’ oil led by US shale producers.
There’s been an enormous of hype recently about the new phenomenon that is shale oil – and if you listen only to the rhetoric emanating from the USA from brokers, deal-makers, drilling-rig operators, company executives and government official, you’d be led to believe that the economics of shale oil are beyond question.
But the truth is a somewhat different story. Sure, there has been a veritable tidal wave of new oil produced from various US shale formations over recent years, but the commerciality of this oil has been underwritten by a persistently-high oil price environment over recent years (we’re talking north of $100 a barrel).
Without high oil prices, most shale oil isn’t commercially viable.
The ‘race to the bottom’ since mid-2014 in terms of rival producers maintaining high output levels in order to see who will crack first in a low oil price environment, means we’re currently experiencing a period of artificially low oil prices.
However, as we’ve witnessed historically (for example during the worst of the Asian economic crisis from 1997 when oil prices fell to $10 a barrel), a period of exceptionally low oil prices is unlikely to last for long – and results in an often rapid and violent price rebound.
There are two fundamental reasons for this. Firstly, most conventional and unconventional oil producers require an oil price of at least $80 (and ideally closer to $100) in order to generate margins robust enough to not only generate a profit, but also to reinvest in new oil discoveries and infrastructure. If prices stay low, vital research and development doesn’t take place, meaning future oil supply is impacted.
Low oil prices now mean that spending to identify new oil discoveries will likely be delayed or even abandoned, disrupting the future flow of oil to market and likely leading to significant price spikes in the future. This is a pattern that’s been repeated through many cycles within the oil industry.
The second reason oil prices won’t stay low for long is the fact that oil industry participants are wise enough to recognise that geopolitical risk is one of the biggest issues historically confronting the industry – and can flare up at any time.
The fact that so much of the world’s oil is sourced from high-risk jurisdictions means that traders and end-users will rush to buy oil at low prices, knowing that the next geopolitical episode is often not far away.
Historically, geopolitical risk has often accounted for at least 20% of the total cost of crude. Given that crude demand is highly-inelastic (not very responsive to rises and falls in price), geopolitical events can quickly tip the scales of the supply-demand equation in favor of demand.
Geopolitical risk sent crude prices skyrocketing during the Arab oil embargo during the 1970’s, whilst geopolitical events like the Arab Spring did sent crude up by $10-$15 per barrel as well.
If one casts one’s your mind back to the middle of last year, oil was trading solidly above $100 a barrel, driven by geopolitical risk concerns involving Russia-Ukraine, Iraq-Syria, Libya and the spread of Islamic fundamentalism elsewhere in the Middle East and Africa. Fast forward to the present day and oil prices have plunged to below $50 a barrel, but the geopolitical situation has escalated.
More recently however, market participants have become less concerned about geopolitical events. Whenever news of a geopolitical event has hit the newswires, Brent crude has no longer rallied like it used to.
Some have attributed Brent’s lethargy to more stringent rules over what investment banks could and could not trade. The thinking is that because investment banks couldn’t speculate as much on crude as they used to, crude itself would trade more in line with its underlying supply and demand fundamentals.
These fundamentals are soft, as a direct result of weak underlying Chinese and European demand. In hindsight, Brent’s lethargy can also be traced to the market’s anticipation of the coming crude correction.
Despite the substantial fall in crude prices over recent months, crude is still heavily oversupplied. A month ago, the EIA reported that oil inventories rose by 7.7 million barrels, versus expectations of just a 3.2 million barrel increase. A fortnight ago, the EIA reported that oil inventories rose again by another 8.4 million barrels versus expectations of a 3.7 million barrel increase.
There are also reports that Saudi Arabia is actually increasing production in order to maintain market share and further pressure US shale producers.
From our perspective however, despite oil’s current ugly supply and demand picture, there is a case to be made for optimism, as I believe geopolitical risk is making a comeback.
Geopolitical troubles in Libya and Iraq continue to rage on, with little prospect of resolution in sight. Libya, Libya is now producing less than 300,000 barrels of crude a day, versus 1.6 million barrels a day during 2011. Given that many countries have pared their social programs due to low crude prices, the probability of another Arab Spring is also significantly higher than before.
All it takes is for geopolitical risk to spread to a major OPEC producing country and the supply and demand picture will look much better. The OPEC ministers themselves are aware of the geopolitical threat – the organization is considering holding an emergency meeting if crude prices continue falling.
From a demand perspective the biggest factor remains China – its economy needs to recover solidly for supply and demand to correct itself – and so far a Chinese recovery is not on the horizon.
To conclude, whilst we as motorists and consumers are enjoying the current low oil price environment, the evidence of history indicates that this situation must inevitably lead to higher prices over the long run. Exploration for new oil fields is a hugely expensive and risky business and companies will only be incentivized to explore if the returns justify the enormous outlays. Likewise, investment is required to maintain and revitalize production infrastructure.
I believe that the current low oil price environment will not and that after a period of price consolidation over the next few months, we will begin to see oil prices recover during H2 2015.
