Following several requests, we decided to write an article concerning oil prices to identify:
1) The main factors which explain the recent weakness.
2) What to watch to catch the next move.
Before starting, we would like to thank our friend, Christophe Barraud, Chief Economist & Strategist at Market Securities but also Top Forecaster of the U.S. Economy, who sent us a lot of stuff in order to complete our views.
It is important to remember that the short term supply and demand curves for oil are very steep which means that a small shock on one side has significant consequences on prices. However, in recent months, there were both a sharp increase of supply and a lack of demand.
1/ U.S. output expanded to the highest levels in more than three decades thanks to “shale gas revolution”. The quadrupling of oil prices between 2002 and 2012, associated with significant technological improvements in hydraulic fracturing technology and horizontal drilling (increasing productivity and lowering costs), created conditions for a second shale revolution. As a matter of fact, in 2005, according to the North Dakota Industrial Commission, almost 200 wells were producing oil in the Bakken formation. The number of wells soared to 2,000 by 2010 and more than 8,000 in 2014. In this context, production from this area surged from 2,500 b/d in 2005 to 250,000 b/d in 2010 and more than 1.1 million b/d by the end of 2014.
Other output increases have come from the application of fracking techniques in Texas (Barnett, Eagle Ford, Haynesville), Oklahoma (Woodford), Arkansas (Fayetteville), Pennsylvania & West Virginia (Marcellus)…
The result has been an extraordinary rebound in U.S. oil production. According to the EIA, Output has surged from just 5 million b/d in 2008 to an average of more than 8.5 million b/d in 2014 and now remains above 9 million b/d at the start of 2015.
2) Signs of a return of Libyan production to historical levels (end of supply disruptions). Libya’s production, which had dropped to 250,000 barrels per day (b/d) in April, May and June 2014, from around 1.8 million b/d before the civil war, rebounded to almost 900,000 b/d over the following three months. The increase was significant mainly because it was unexpected. However, according to Reuters, since the beginning of 2015, Libya has produced just 350,000 b/d due to rebels’ attacks in the south.
3) Oil output in Russia (non-OPEC) surged to the highest levels in decades in December 2014. The surge in supply in Russia signaled no respite in early 2015 from the glut. Russian output rose 0.3 percent in December to a post-Soviet record of 10.667 million barrels a day, data e-mailed by CDU-TEK, part of the Energy Ministry, showed.
4) Prices war began with OPEC (Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, U.A.E, Venezuela). Throughout the end of 2014, speculation intensified about possible production cuts by OPEC members, led by Saudi Arabia, to support prices. Nevertheless, the Saudis downplayed this scenario (even After King Abdullah’s Death). Saudi officials informed specialists not to expect production cuts and indicated that the Kingdom was ready to allow prices to slide. The fact is that cutting production to sustain prices at an artificially high level would only sacrifice Saudi Arabia’s and OPEC’s market share and allow shale production to continue expanding. Instead, the Kingdom determined to allow prices to fall low enough to begin curbing the investment in new shale wells. Note that that this move was facilitated by the dollar’s strenght againt major currencies which allows OPEC producers to rebalance their public finances (reducing import costs). Without surprise, according to Bloomberg, OPEC pumped above its quota for a seventh month in December
5) Higher capacity of storage. After a decade of investment, substantial excess storage and tanker capacity suggest the market can run a surplus far longer than it has in the past. As an example, in its latest weekly report (Jan. 23), the EIA showed that “U.S. commercial crude oil inventories (excluding those in the Strategic Petroleum Reserve) increased by 8.9 million barrels from the previous week. At 406.7 million barrels, U.S. crude oil inventories are at the highest level for this time of year in at least the last 80 years.”
***Lack of demand
1) Demand destruction in developed countries. According to the WSJ, “the US is experiencing the largest and most sustained drop in oil demand since the start of the petroleum era in 1859 thanks to improvements in efficiency and the switch to alternative fuels. Quietly and almost unnoticed by most commentators, efficiency and fuel switching are making an even bigger contribution to the North American energy revolution than hydraulic fracturing and horizontal drilling. Fuel savings have contributed more barrels to the supply/demand balance than the combined output from North Dakota’s Bakken and Texas’ Eagle Ford. Efficiency gains and the switch from crude oil to natural gas and biofuels have cut the consumption of petroleum products in the US by more than 2 million barrels per day since 2005, according to the Energy Information Administration. If consumption is adjusted for the rise in population and economic output, oil use has actually fallen by between 3 and 4 million barrels per day compared with the previous trend.” The fact is that the soaring cost of gasoline, diesel and jet fuel encouraged motorists, truck operators and airlines to do everything possible to reduce fuel consumption in all developed countries.
2) Asia slowdown. Demand destruction in the United States, Europe and Japan provided room for rapidly developing economies in China, Southeast Asia, Latin America and the Middle East to increase their own fuel consumption without repeating the 2008 price spike. However, in Asia, too, there were signs in 2014 and early 2015 that consumption growth was slowing in response to a general slowdown across the region. The fact is that Chinese officials are still implementing structural reforms which imply less growth and a shift toward services’ industry instead of manufacturing. In this context, growth prospects have weakened and that’s why the IMF slashed its growth expectations again, putting the country’s expansion in 2015 at the lowest rate in 24 years.
3) Geopolitical tensions. An escalation in geopolitical tensions between Russia and Europe concerning Ukraine’s situation, resulted in a tightening of sanctions which pushed Russia into severe recession as soon as 2015. The negative effects also weigh on European exports and should last given that fights in Ukraine have intensified since several days in Donetsk, Luhansk and Mariupol.
4) U.S. weather. Weather conditions were particularly mild in December. According to the national climatic data center, this ranked as the second warmest December on record, and the warmest since 1939. Every state in the contiguous U.S. had above-average December temperatures, with nine states across the West, Southern Plains, and Northeast having a top 10 warm December.
***What to watch to catch the next move?
1) The response of the shale drillers – how far they cut drilling and production rates, and how far they can improve efficiency and cut costs to reduce the breakeven price for new wells and sustain production in a lower price environment. Breakeven prices for shale wells range from as low as $30 per barrel to as much as $75 or more, that’s why drilling activity in North Dakota’s prolific Bakken field is already falling so that production is expected to drop by summer. As a matter of fact, North Dakota’s commissioner of mineral resources, Lynn Helms, said on Jan 14th that in many areas of Bakken, break-even costs already exceed current oil prices and companies are shutting down development.
2) OPEC willingness to cut production by mid-2015. Given the situation, such a move seems unlikely in the short term.
3) Global growth. An upside surprise is likely given the global accommodative monetary policy (increasing balance sheet, cutting rates).
4) Geopolitical tensions around Ukraine. EU and Russian foreign ministries are trying to implement Minsk agreement which could result in easing mutual sanctions as early as March 2015, however, recent developments suggest that the conflict should persist and could even lead to more reciprocal sanctions.
5) U.S. weather. Heavy storm and blizzard used to hit the East Coast in winter and could lead to a peak of consumption.