The Oil Rebound, Head-fake or Structural Recovery?

Reading the news about future oil prices can be very confusing these days, especially when one tends to listen to the experts. Only three weeks ago the secretary-general of OPEC, Abdalla El-Badri, stated that price surges to over 200 USD a barrel are possible. Hardly two weeks later Citigroup’s global head of commodity research, Edward Morse, wrote that oil prices could fall as low as 20 USD a barrel in the near future. Which one of them is right? Or are they both wrong? In this article I will analyze different factors that drive oil prices, and give my personal opinion on the matter.

The astronomical price of 200 dollars is not just made up by El-Badri: in his view underinvestment will lead to a shortage in oil production. He states: “If you don’t invest in oil and gas, you will see more than 200 dollars when it comes to future oil prices.” Indeed it appears that this annum oil producing companies will cut planned capital expenditures between 13% and 64% year on year, with the larger integrated companies on the lower end of this range and the smaller more financially leveraged companies on the higher end. Bloomberg reports that the recent oil price implosion has already wiped out more than 100,000 jobs worldwide thus far and that drilling rigs are still being closed down.

Nevertheless, shale production in the US will increase by almost 300,000 barrels a day in the first quarter of 2015 according to the US Energy Information Administration (EIA), which is shown in the graph above. American companies have thus far idled over 150 drilling rigs since October. However, more than 200 additional rigs need to be closed to keep production flat, and this number is even without acknowledging future efficiency gains. These efficiency gains are not to be ignored, as companies keep getting better at blasting oil and gas out of the ground. For example, the Bakken formation in North Dakota pumps up 551 barrels a day for each rig it has in its field, which is twice the amount it produced per rig three years ago. Moreover, the reported drop in rigs only concerns the older machines, the newest and most efficient equipment is dispatched to the most promising fields. A somewhat similar situation has occurred before with natural gas production. The graph below shows the severe drop in gas rigs over the last couple of years, while the production of natural gas continued to rise steadily due to the massive increase in efficiency leading to lower gas prices.

So far, I have only addressed US shale production. In other, high-cost production regions, however, downward adjustments are to be expected, for example in the North Sea and parts of Asia. If the prices remain this low, North Sea operators might be encouraged to accelerate decommissioning plans for their currently uneconomic platforms. Other, lower cost producing countries, however, do not seem to cut back supply. Russia and Brazil reached record levels of output of respectively 10.7 and 2.5 million barrels daily in December, with Russia maintaining these high levels in January. But this does not mean that the future looks bright for Russian production. Although it is not directly affected by the low oil price itself because of the severe Ruble depreciation lowering relative production costs, it is hit by Western sanctions which complicate access to drilling technologies. Furthermore, external debt financing costs have been rising as some large Russian oil firms have high US dollar debt commitments caused by the low Ruble. On the other hand, Saudi Arabia, Iraq and Iran are not willing to cut back production in order to get prices back to higher levels, anxious to lose market share. They keep cutting their oil prices to Asia in order to retain market share, with Iraq even increasing its exports. They do this while their heavily troubled OPEC counterparts Venezuela and Nigeria are expected to see a slight decline in output as a result of lack in investments. Furthermore, Brazil, Canada, Colombia and China are also likely to see small production declines in 2015. The graph below shows the crude oil production and consumption forecast.

Historical experience indicates that low oil prices have a positive impact on demand, both directly though lower prices on petroleum and indirectly through positive shocks in GDP. Customers in OECD countries are among the major beneficiaries as they see their retail prices decrease and in these countries some growth in demand will be possible. However, a considerable amount of non-OECD countries had retail price controls and subsidies in place to shield consumers from the recent high oil prices. Demand growth in these countries is expected to be limited, as governments will cut subsidies now that oil prices are low in order to reduce their fiscal burden. In the graph below one can see that the demand growth for oil is much lower in the coming years than it was in 2010 when it caused oil prices to surge back to triple digits again.

As I already highlighted in my previous article, current low crude prices are in my opinion caused by fundamentals: high supply, lacking demand and a strong dollar. None of these factors have changed much since then, but surprisingly enough oil prices have rebounded from their 5.5 years low of 45.45 dollar per barrel in recent weeks. This started on the 30th of January, when oil prices surged more than 8% in one day after the announcement of a record weekly decline of US drilling rigs, eventually leading to prices of almost 53 dollar for WTI and 62 dollar for Brent today. However, as I stated above, a decline in oil rigs does not necessarily mean a decrease or even a flattening of the pace of US oil production and the growth in global demand does not seem to be sufficient to tighten the heavily oversupplied oil market. At the moment the amount of oversupply is estimated at a whopping 1 to 1.5 million barrels per day. Furthermore, there is a significant build in inventories in the recent months and a huge amount of oil is stored on floating tankers and other vessels as on-shore storage tanks for oil products become either full or have no more unreserved space available. When floating storage also reaches its limits, there may be an even higher downward pressure on prices as oil that cannot be stored will flood the markets.

As long as oil prices will go up slightly, the crude markets will not rebalance. We need a longer or more severe drop in prices to really make the producers feel the pain and be forced to cut back production, or for demand to go up significantly. Even if prices will continue to rise gradually in the coming weeks, I am inclined to stay bearish on crude oil since this would trigger US shale producers to hedge the prices of their future production in 2016, once future prices rise above their production break-evens again, and may encourage a re-expansion of 2016 drilling plans.

My forecast for the coming months is a drop of at least 10%, maybe even more, after which the oil prices will bottom out in the second quarter of this year and may eventually gradually start to rise again in the second half of 2015. But unfortunately for OPEC, all other things held equal, I do not see prices going into the triple digit zone again and definitely not to levels above 200, as was boldly claimed by El-Badri. Of course, all other things may not be equal and geopolitical events may affect oil prices as we saw in recent years when some of the biggest supply disruptions in the oil market’s history took place. Disruptions in oil production might arise from the civil war in Libya and Syria, expansion of the Islamic State in Iraq and Syria, sanctions that keeps Iran’s crude exports low and tensions between the Russia and the West.