An oil price rebound? Not so fast
27 January 2015
The real reason for the oil price collapse is probably that the market has now realised that prices were previously propped up on premises that are less valid now. When majority of the market participants accepted that, prices had only one way to go — down. By Shivshanker Verma
If anyone needed a good pictorial representation of the phrase 'falling off a cliff', a line chart of crude oil prices for the last four months of 2014 will do a good job.
It looked like a modest correction when the decline started in September, but soon turned into a cataclysmic dive. Anyone with a fair understanding of the structure and dynamics of the global energy market would have been stunned. It was completely out of the blue, and foreseen by not a single respected energy market analyst.
The most pessimistic 2014 year end forecast for Brent crude among Wall Street analysts tracked by Bloomberg was $86 per barrel. As I write this, Brent has slipped below $50 a barrel.
The reasons for this dramatic collapse in oil prices have been extensively analyzed in every media. Higher US production, weak global demand and strategic play by OPEC led by Saudi Arabia are some of the popular, and evident, causes being talked about.
Those attracted to international political conspiracies would have liked the hypothesis that this is a short term crash engineered by the Americans and Western Europeans to bring down Russia. Vladimir Putin and some of our CPM and CPI comrades might agree.
Now some analysts and commentators are predicting a quick rebound in oil prices. They are still a minority, but their numbers are slowly building. Their reasons are quite logical too.
First, there are far too many geopolitical hot spots in energy producing countries that could blow up anytime. Any event big enough to take out two or three million barrels a day of supplies from the market will push up prices.
Second, the market is being too pessimistic about demand forecasts. Any improvement in global growth could lead to higher oil demand and prices.
Finally, and most importantly, many high cost producers will be making losses at prices below $50 a barrel. They could be forced to continue production to service debt or meet other obligations, but cannot continue for long. As they go bankrupt and stop production, oil prices should recover, the optimists theorise.
If we look more closely, there is nothing new here. These are the same arguments that bullish analysts talked about before prices started tumbling. If not for the several geopolitical risks, there was no rational explanation for Brent crude to trade above $110 a barrel when the global economy was growing at only around 3.5 per cent. Every year since 2008, oil analysts had said demand recovery was just around the corner. But the world never seemed to reach that corner.
After a nearly 60-per cent plunge in oil prices, these same arguments shouldn't hold anymore. For that kind of a price change to occur, in a relatively calm environment, there has to be structural shifts happening in the market.
Starting from the '80s when rising Saudi production triggered a steep fall, the oil price declines over the last several decades were also caused by clear changes in demand or supply.The 2008 crash was somewhat unusual, as it happened in a highly volatile environment, when the global economy was facing a deep recession.
This time, the triggers that supposedly caused the crash are insufficient to explain the velocity of the price fall. US oil production has been rising for several years now, and the expected increases in the coming years were also widely known in the market.
The Middle East remains volatile, with the ISIS threatening the stability of leading oil producers such as Iraq. Putin had braced himself for a long fight, until the oil crash cut his swagger.
There was no sudden downward shift in demand anywhere in the world either. On the contrary, economic growth in the US, the world's largest oil consumer, is accelerating. The Chinese are still buying more than 20 million vehicles every year, and are likely to do so for the next several years. If anything, the demand outlook is much better than it was for most of last year.
The real reason for the collapse is probably that the market has now realised that prices were previously propped up on premises that are less valid now. When a majority of the market participants accepted that, prices had only one way to go - down.
If we go back a few years before the financial crisis, when the great commodity super cycle was raging, most analysts were confident that oil prices would remain high for years or even decades.
It was widely-believed that most of the major oil reserves had already been discovered and aggregate global oil production was about to peak. With surging demand in China and other developing countries, it was easy to postulate that oil prices should remain high.
But high prices also force consumers to be more frugal, encourage innovators to come up with new technologies, and push policy makers to support alternatives. The results of all these actions in the energy market are now clear to us all.
If we look at the US market, the shale oil boom was the market response to high oil prices. If oil prices had not soared before the financial crisis, billions of dollars of investments would not have flown into shale oil fields.
Fracking technology was developed to bring oil reserves that were previously inaccessible, or commercially not viable. Not all of these oil producers would shut shop and go away because prices are much lower now. Some of them will try to cut costs and survive, expecting higher prices in future. So don't be surprised if US oil production does not decline much, even if low prices persist.
On the demand side, Americans don't drive as much as they used to. New vehicles are far more fuel efficient than the vehicles they replace. The latest version of Ford F-150, the best-selling vehicle in America for the last several years, is lighter and consume less fuel. The net effect is that, even though the US economy has recovered, total crude oil consumption is almost 10% below the pre-crisis level.
Government regulations mandate that car manufacturers keep improving engine efficiency to meet higher targets. So, manufacturers cannot cut down their research spending on improved engine technology even when their consumers are not worried about fuel costs. This is true for most developed countries.
Even in China, and other developing countries, demand growth could slow down.
Gains from more efficient engines should reflect in these markets as well. Auto sales volume growth in China was below expectations last year, and is not expected to see the strong double digit gains of earlier years. Most major Chinese cities are now facing severe traffic congestion, and are trying to restrict the number of new cars being added.
The global energy market is not a sellers market anymore. Among the major oil producers, there are quite a few countries that have no choice but to ignore low prices and keep pumping oil.
Their economies and government budgets have become so over-dependent on oil revenues. In the absence of other revenue sources, governments in these countries would force their national oil companies to maintain production. Or even increase output, to make up for lower prices.
The dreaded geopolitical risks are not so threatening, if we ignore the media scare and get a more realistic picture. Putin's popularity will soon drop as Russians start feeling the bite of recession, and he won't think of military adventurism for the next several years.
Yes, if ISIS manages to completely take over Iraq and Syria, or enter Saudi Arabia, oil prices will bounce back. But, with the US and its allies pounding the militants with incessant air strikes, how long can ISIS remain a viable threat?
These are the realities the oil market chose to ignore until August of last year.
Prince Alwaleed bin Talal, billionaire investor and a Saudi royal, said this week that oil prices may never regain $100 per barrel. He could be wrong in the very long term. But for the next several years, oil prices will struggle to remain above $70 per barrel for extended periods. It's time for the consumers, to enjoy the ride.