It has been a rough 2 years for forecasters of crude oil prices. Essentially no one saw the 2014 crash coming, and everyone looked on in surprise as a barrel of crude oil tanked, from over $100 to less than $30. After the crash, many forecasters expected a speedy recovery driven by bankruptcies in U.S. Shale, only to be left surprised again by the slow pace of the structural adjustment of supply to demand, causing the crude oil price to remain in the $30 to $50 per barrel range much longer than anticipated. And now, just as everyone has begun forecasting “lower for longer”, crude oil seems to be breaking through the $50 per barrel range in response to the announcement that OPEC and Russia intend to cut production.
All these surprises did not happen because crude oil price forecasters are “quacks” and “charlatans” who don’t really know what they are doing. Rather, the issue is the large number of real world factors that impact the crude oil price – economic growth; interest and exchange rates; demographics; global, regional and local politics; weather conditions; et cetera – and the general unpredictability of these factors. On top of this, the global economy’s financial markets have made it possible for the crude oil price to move disconnected from these factors. Speculator sentiment can make the crude oil price move in anticipation of an event, that is before something has actually happened, and by more than is justified by the event (“overshoot”).
Clearly, this makes crude oil price forecasting exceptionally difficult. That does not mean, however, there is no value in doing it.
If it hadn’t been for crude oil price forecasts the world wouldn’t have known about many of the factors impacting the crude oil price. The reconciliation of the forecast and the actual price of crude oil often results in learning about new things with implications for the crude oil price, new factors which had not been considered before. U.S. shale’s ability to innovate is a recent example. In other words, while crude oil price forecasts might not always be accurate, if done well they do always support development of critical insights into the crude oil market.
That this enhanced understanding of how the world of crude oil works has not resulted in increased accuracy of crude oil price forecasting, is because the world continues to increase in complexity. New factors continue to be added to the pool of factors of affecting the crude oil price, often times upsetting the effect of established factors. In a business with a long term horizon such as the crude oil industry, where exploration, development and production can all take years, added complexity substantially adds to uncertainty. The oil industry has developed management techniques to deal with this uncertainty, such as scenario planning and strategic risk management. Crude oil price forecasts are a critical input for these tools to function, which means that crude oil price forecasting is an impactful value creation and preservation tool.
With the value of crude oil price forecasting firmly established, we will continue to monitor the global crude oil market to assess how events and trends will be impacting the crude oil price. At present we are bearish for crude oil, as we believe the following factors will be driving the oil prices in the short to medium term.
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Downside Risks OPEC
The countries united in OPEC at present account for approximately one third of global crude oil production, giving the OPEC cartel significant ability to influence crude oil supply and market sentiment. The recent announcement of an agreement to cut production sometime in November 2016 effectively signaled a change in course. Since 2014 OPEC’s strategy had been to “protect market share”. Now it seems to be returning to a price management strategy.
OPEC’s ability to deliver on this strategy remains doubtful. The allocation of the announced production cut amongst the OPEC members still needs to be agreed, for example. Since essentially all are struggling under the low oil price, this will not be easy to achieve. The reported disagreement amongst OPEC members on production statistics signals a behind-the-scenes disagreement about next steps.
If an agreement is established, the cartel’s history of members cheating on formal agreements, leading to actual production coming in higher than formally agreed, will need to be managed. Amongst the tools historically used by OPEC member states to avoid being impacted by an agreed cut is increasing production before the cut becomes effective. As OPEC reported record production of 33.6 million barrels per day during the month of September 2016, at least some of the OPEC countries appear to have resorted to this tactic this time round as well.
There is also the question of how much exactly an agreed production cut will impact the number of barrels supplied to the international markets. For example, during summer Saudi Arabia uses over 1.0 million barrels of crude oil for power generation, in order to deal with peak power demand associated with air-conditioning. Now that summer is over it can easily afford to lower production by 0.5 to 0.75 million barrels per day since that would not affect the number of barrels of crude oil it offers for sale to international buyers.
The crude oil price seems to have already factored in an effective implementation of OPEC’s stated intent to reduce supplies. Consequently, we don’t expect “OPEC success” in November to raise the crude oil price much higher. On the other hand, if OPEC fails to deliver a real reduction in the number of barrels it supplies to the global markets, this could push the price back down to the $45 level.
Global Economic Growth
The two-way relationship between economic growth and energy demand, and by extension crude oil demand, is well established. As economies grow they tend use more energy. Conversely, the availability of (cheap) energy enables economies to grow. For this reason global economic growth forecasts feature prominently in crude oil demand forecasts.
The fact that global economic growth has consistently been overestimated the last few years therefore substantially contributed to current supply glut. In essence, the crude oil industry invested billions in anticipation of demand that never materialized.
A consensus seems building amongst economists that in the short to medium term, global economic growth will be less than what the world got used to in the post WWII period. The IMF, for example, has warned for a coming period of mediocre growth, under the influence of factors that according to some are not easily resolved and according to others can not be resolved at all.
But even mediocre growth is under threat, and thus also even the least optimistic of crude oil demand growth forecasts.
Many of the globe’s key economies are struggling. In Japan Abenomics are by now considered a failure. In Europe, where the euro debt crisis remains lingering, Brexit has raised additional concerns about the future of an economic growth that already was “sluggish” at best. Regarding China concerns remain that the real growth slowdown is much worse than the official statistics indicate.
Hanging over all of this like a thick dark cloud is a global debt which has reached record levels. As long as interest rates globally remain at their current record low levels, this will not cause any issues for economic growth. But in today’s a low growth environment an increase in rates obviously would, which would have a knock-on effect on global crude oil demand. In China the debt issue seems to be a particular concern at the moment.
As energy efficiency is becoming more and more a focus area of governments around the world, reducing the impact of economic growth on crude oil demand growth, there is a high probability that crude oil demand growth will continue to disappoint, which would keep the price locked at around $50 per barrel, the price of the marginal barrel at the moment.
Chinese Oil Demand
China was instrumental in the crude oil supercycle that lasted from 1999 to 2014, as during that period China’s crude oil demand grew by an amount equivalent to the total oil consumption of Japan and the United Kingdom. The country is now the world’s largest crude oil importer.
Although growth of the Chinese economy has slowed down over recent years, Chinese crude oil demand has continued to grow at the previous pace. This is because China has been using the low oil price environment to fill up strategic and commercial storage. According to some, China has been buying 0.5 million barrels per day on average in 2015 and 0.9 million barrels per day on average in 2016.
Obviously, this demand can not last forever as at some point China’s storage capacity will be full. It is not known exactly how large this capacity is, or how full it is at present, but as the buying associated with strategic storage is slowly phased out, China’s crude oil imports will stop growing or even decrease, taking the crude oil price down with it.
Technological Innovation & Process Optimization
At the beginning of 2015, most crude oil price forecasts assumed US shale to respond quickly and lower production, since the typical shale production cost at that time was substantially higher than the crude oil price. This expectation never materialized, however. Total US crude production dropped by just 0.8 million barrels per day between April 2015 and May 2016, because the US shale players were able to drastically lower their cost of operation. In part through renegotiating contracts with suppliers and service providers, but also through innovating and optimizing their processes.
While some of the savings from contract renegotiations will be undone during the upcoming period, shale innovation should be expected to continue to lower the production cost. In more conventional areas a similar trend to drive operating costs down through innovation and process optimization can be witnessed, with some success stories already. Effectively, this will result in increased crude oil supply at every possible price range (ceteris paribus), and thus put downward pressure on the crude oil price.
Crude oil has been a remarkably stable industry for most of its existence. While the technologies applied to finding, developing and processing crude oil have indeed changed substantially, the products itself was never seriously challenged by outsiders, i.e. by new solutions for humanity’s energy need. Until recently, that is.
Under the influence of factors such as emission control regulation, changes in consumer preferences, digitalization and urbanization, the auto industry is presently going through transformation change. One of the changes is a move away from the internal combustion engine towards electric and fuel cell vehicles.
As some two thirds of crude oil demand is linked to transportation, this could have far reaching consequences for the crude oil industry, deflating global crude oil demand by millions of barrels per day as soon as early as 2030.
Opposite these substantial downside risks for the crude oil price we see just two factors that bring an upside potential, namely Upstream underspending and geopolitical risks.
Major cutbacks in exploration spending following the 2014 crude oil price collapse have resulted in new crude oil discoveries dropping to a 60 year low in 2015. On top of this, spending on production maintenance for mature fields has also been greatly reduced, the first effects of which are beginning to show in the production numbers.
The global average for natural decline rate for mature fields has been assessed at around 6 percent annually. Therefore, unless spending on exploration and mature field production maintenance recovers during 2016 and 2017, there is a substantial chance that 2 to 3 years from now the crude oil market will return to a state of shortage, which for an intermediate period at least could push the crude oil price up to $80 per barrel, the price needed to spur on investment in long-cycle projects such as deepwater, or possibly even higher.
The war in Yemen is a geopolitical conflict with the potential to impact the crude oil price in the short to medium term, for two reasons.
Firstly, Yemen itself borders a key transport route for crude oil. Some 5 million barrels of crude oil pass through its Bab Al Mandab every day. Recently, the area has been drawn into the conflict. A worst case scenario for the conflict is a further escalation which closes the Bab Al Mandab for commercial shipping entirely, forcing crude oil transports from the Middle East to Europe and the Americas to take the much longer route around the Cape of Good Hope instead of through the Suez Canal.
Secondly, behind the war in Yemen is a conflict between Saudi Arabia and Iran. It is not impossible for the war in Yemen to spill over into other areas of the Middle East, which, at 31 million barrels per day, is home to around 35 percent of global crude oil production.
Other geopolitical events with a more remote likelihood of impacting the global oil markets are Iraq, in particular the battle for Mosul which is of course a key oil producing area, and the battle against ISIS, in particular in Libya where the group has been threatening the major oilfields in the eastern desert of the country.