INVISIBLE HAND: Sowing the seeds of an oil-price rise

By bne IntelliNews February 19, 2015

Liam Halligan -


Is the oil price crash over? In mid-February, Brent crude traded at $63 a barrel, up from a $45 low a month earlier. Does that sharp rise mean oil will now climb steadily back above $100?

Triple-digit oil prices, after all, have become the normal in recent years. The black stuff spiralled to almost $150 in late 2008, ahead of the global financial crisis – before falling back, as the world economy endured it worst peacetime shock for 80 years and asset markets collapsed.

As global growth returned, though, and traders remembered that the populous emerging markets were still becoming more populous, their energy demands ever rising, oil quickly recovered. During the three and a half years from early 2011 to mid-2014, oil was above $100 pretty consistently. Prices then started falling last June, by some 60% to their mid-January low. But Brent crude is now up 36% during the four weeks to the time of writing. So has the oil market now turned?

Temporary dip

Forecasting the oil price is a mug’s game. But crude is so important to modern life, and the path of the global economy, that for all the prediction pitfalls, any decent economist needs to take a view. With energy importers like the US and EU benefitting from cheaper oil and exporters suffering, price predictions can often appear partisan –  driven more by emotion than rational analysis.

During these recent months of East-West conflict, I’ve heard numerous Western analysts express pleasure at the impact of cheaper crude on the Russian economy, for instance, while happily predicting further falls – perhaps without thinking about the painful impact on their own energy producers (in the UK’s North Sea, for instance, or US shale fields).

My (entirely data-driven) opinion is that the price dip is temporary and, even after the recent increase oil remains heavily over-sold. But prices aren’t always driven by data, of course. So we could easily see oil temporarily drop further, in another speculative short-selling frenzy.

Eventually, though, supply-and-demand realities apply. In my view, the fundamentals – high drilling costs and pitiful discovery rates on the supply-side, coupled with ever-rising global demand – point to oil between $80 and $120. I’d also say that – beyond the hype, and the fact that traders must react in the short term to hype if everyone else is reacting, even if they don’t accept it – such fundamentals are widely understood. As such, unless we see another 2008-style systemic meltdown on global markets, I’d venture $100 will be back in sight towards the end of 2015.

To understand why oil prices are likely to recover, we must understand why they fell. One major reason is Janet Yellen. Last autumn, the Federal Reserve chairman announced that the US is to rein-in quantitative easing. Since then, on the strength of less virtual money-printing, the dollar has surged. The passing of the QE baton back to Japan, with the Eurozone about to follow, has helped drive the greenback to a near seven-year high against the yen and the euro to an 18-month dollar low. Given that oil is priced in dollars and all major Opec producers peg their currencies to the dollar, when the US currency rises, the quoted oil price axiomatically falls – which is what we’ve seen since Yellen made her move.

I believe that, for all the huffing-and-puffing between Athens and its creditors, a deal will soon be cut to keep Greece in the Eurozone. Germany has blinked during every previous euro crisis and Berlin has too much political capital invested in monetary union to allow “Grexit”, which could then see other “Club Med” countries leave, threatening not just the euro but the entire “European project”. After a Greek settlement, and once euro-QE kicks in, the single currency will strengthen. That will push the dollar down over the coming months, raising headline oil prices.

Another reason oil prices fell from last autumn, of course, aside from the dollar, was the wave of new crude extracted from “tight” oil formations in America. Since 2009, US shale oil production has grown from almost nothing to 4% of global output. That’s driven the US' total crude production up from 7.5mn to around 10mn barrels daily – approaching peak US production of 11.3mn barrels back in the 1970s.

A supply increase of this magnitude clearly didn’t go unnoticed by the Opec exporters’ cartel. At a time of souring relations between the US and Saudi Arabia – not least due to American overtures to Iran in the battle against Islamic State and support for Qatar, a key backer of the anti-Saudi Muslim Brotherhood – Opec decided not to cut their export quota. Riyadh convinced other cartel members to suppress prices, instead, protecting Opec’s market share by squeezing upstart US shale producers – which have high production costs and often heavy debts – so as to knock them out of the market.

When oil is below $80, many shale producers, particularly the relatively small outfits that have driven US' recent production increase, simply don’t make money. So production stops, as does investment in future wells. American energy companies, large and small, are now rapidly laying off field workers in response to cheaper oil. In January, the US “rig count” was down 10% on the month before, amounting to a drop of no less than a third since October. The number of active domestic US wells has, over just four months, plunged to a three-year low.

Discovery drought

The oil price rise since mid-January admittedly reflects other supply-side developments, not least concerns over fighting in the Middle East. Violence in Libya has lately shut all major ports, reducing oil exports to just a trickle. Iraq's semi-autonomous Kurdistan Regional Government has also threatened to withhold crude exports as part of a broader dispute with Baghdad. Having said that, many traders have been struck by the extent to which high-cost US shale outfits are now suffering due to cheaper oil. While some such producers have hedged their price exposure, many are unhedged as well as heavily indebted, which puts them in a very weak position. Depleting far more quickly than conventional wells, ongoing shale production when prices are low and below cost requires ever more debt capital, which is currently scarce. No wonder, given increasing market chatter about the non-performing loans of US shale producers potentially sparking another “Lehman moment”.

Oil market bears point out, rightly, that after four years of rising US shale production, and an on-going ban on almost all energy exports, US crude stocks are now high at almost 420mn barrels. That puts downward pressure on prices. Having said that, with the US still importing a net 9mn barrels of oil daily, a long way from “energy independence”, this stockpile could quickly deplete. The threat that cheap crude poses to domestic production will also eat into inventories.

While judging between falling US rig counts and high stockpiles, traders have also lately absorbed news that in 2014 global oil discoveries fell for the fourth year in a row – the longest run of annual declines since the 1950s, despite the incentive of $100-plus crude during much of that period. The 16,000 barrels of oil-equivalent found last year was less than half of total 2014 consumption and the lowest for six decades.

While “conventional” crude costs up to $60 per barrel to produce, unconventional oil – shale, deep-water and tar-sands – generally absorbs $80-$100. Over the last decade, more than two-thirds of the 12mn-barrel rise in daily global oil production that has prevented prices spiralling in the face of fast-growing demand has come from “unconventional” sources. Lower prices make much of that production uneconomic while deterring investment in future capacity – sowing the seeds of an upcoming price rise.

The fundamental supply-side trends, then, point to more expensive energy. Then there’s the demand side, where the fast-growing emerging markets now account for over half of total global consumption. In each of the last three years, world production has lagged actual usage by upwards of 3mn barrels daily, mainly due to rising emerging market demand.

While this reality has lately been overshadowed by the US “shale revolution” and the drama of Riyadh defying Washington, the insatiable energy appetite of the East, in the face of ever-rising oil production costs, remains one of the defining economic trends of our time. It will soon reassert its grip on the global market for crude.

Liam Halligan is Editor-at-Large at bne IntelliNews

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