Oil prices: The darkest hour before dawn?

28 Sep

Market players are losing patience with expecting a recovery of oil prices. But an increase from current levels is still likely in a few years, maybe as soon as 2016.

Oil prices are below 80 dollars since November 2014. The monthly average price of Brent reached a local minimum in January 2015 at $48.5/bbl, then started to recover and reached $64.4/bbl in May. Now it is back to below $50/bbl. People are losing patience with expecting a recovery. Goldman Sachs started to talk about oil prices potentially dropping to $20/bbl.

Three factors are likely to be behind the renewed price weakness: stubborn supply from US shale oil producers, OPEC production increase and fears about the Chinese slowdown worsening and spreading to oil demand. The fear of increased production from Iran was the icing on the cake. This led to weak prices, despite demand growing very quickly. The following chart tells the story: demand was increasing 1.8 mbpd yoy in Q2 2015, the fastest increase since the post-crisis bounce-back. Yet supply was increasing even faster, by more than 3 mbpd. This worsened the imbalance and led to the renewed price weakness.IEA_demsup

Source: IEA

It is likely that the supply-demand dynamics will become much more favorable. The supply decline from the US is just delayed, not cancelled. The IEA expects that non-OPEC production will decline by 0.5 mbpd in 2016. Many of the US producers sold production on the futures markets at higher prices, but now are running out of money and lower prices are catching up with them. OPEC spare capacity is fairly low (which by the way means supply disruptions could have a large effect), and low oil prices put a strain on budgets. It is tempting to cut back on investment projects in poorer OPEC countries, and political turbulence may delay new oil production in places like Iraq. Saudi Arabia is increasing rig counts, but it is talking about maintaining market share and not about increasing it is a significant way.

IEA_opecnonopecSource: IEA

Low prices boost demand, and we probably have not seen the full adjustment yet – prices are volatile and consumers have not all bought new, bigger cars. On the demand side, the large question mark is indeed China. It is likely to experience a recession at some point in the next 5 years – and may well be in recession right now, despite official GDP numbers showing a 7% yoy increase. A serious recession could lead to a drop in oil demand, and seems to be the most plausible reason for sustained low oil prices in the next few years. The mitigating factor is that China is switching from an investment-led growth model to a consumer-led one, which means less demand for truck fuel but more demand for cars and airplanes.

Overall, oil prices are unlikely to recover to above-100$ levels any time soon. But at the current price level, depleting oil production is not replaced outside of OPEC. If there is going to be demand growth at all, markets will tighten. On the first chart, the IEA expects the inventory buildup to stop as soon as the second half of 2016. There is a lot of short-term uncertainty, and a lot of volatility is almost guaranteed. But oil prices are likely to be higher in 5 years than they are now.

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