Sustainable oil price is $70-90: ESAI
(ESAI, Energy Security Analysis Inc, is a Massachusetts-based energy consultancy. The opinions expressed here are those of ESAI.)
The crisis is over, economies all over the world are recovering, record unemployment is slowly subsiding, and oil demand is growing. The logical question now is where will oil prices go from here? The question is not what the price of oil should be, as discussed at last month’s International Energy Forum. Likewise, it is not what is the equilibrium price.
Equilibrium price is a concept, offered by classical economists, which asserts that there is a price at which supply and demand balance. Price behavior, especially in recent years, has proven that this is an overly simplistic and unworkable concept for the oil market. There is never a point in the global oil market when supply equals demand, and thus there is no such thing as an equilibrium price. The right question is what is the fundamentally sustainable price?
The distinction between equilibrium and sustainability is important.
Equilibrium implies perfection and stability, ideas that are not endemic to the modern global oil market. Sustainability is a created word from the environment community that implies the ability to maintain or endure. Whereas equilibrium suggests certainty, sustainability suggests survival amidst uncertainty.
The difference between a market that is perfect and stable and one that endures has implications for forecasting. In short, it is foolhardy to try to project an equilibrium price, but identifying a fundamentally sustainable price range is a useful endeavor.
So, in answer to the question, what is the fundamentally sustainable price, the answer is not a number. It is a price range within which prices are likely to move for some time based on expected overarching supply/demand fundamentals.
As shown in the following graphic, ESAI believes the fundamentally sustainable price range today and generally for the next two years is $70-$90.
Moreover, as the graphic implies, the fundamental signals were indicating a downward slide from the recent highs (mid-$80s) within the price range. In short, rising inventories are signaling that supply is temporarily outstripping demand and prices are likely to weaken, but generally stay within the sustainable price range.
WHY $70-$90 PER BARREL
ESAI estimates that the sustainable price of oil over the next two years is $70-$90 based on the most important fundamental signals. These include:
1. The marginal cost of non-OPEC production is set by Canadian oil sands and that cost (on a delivered basis) is over $65 per barrel. This puts a flexible floor under prices for a period of time.
2. The recession reduced oil demand so significantly and OPEC responded so effectively that OPEC spare capacity has accumulated. Even with recovering demand, the reduction in OPEC spare capacity will take time. This spare production capacity puts a flexible ceiling on prices.
3. OPEC’s newfound spare capacity strengthens its hand in influencing prices. If OPEC has the will to do so, it can prevent a significant fundamental price rally by adding oil to the market. It is ESAI’s opinion that OPEC has too much to lose with regard to demand response and environmental urgency to let the price rise significantly above the sustainable range and stay high for an extended period of time. Even in the best of circumstances, however, OPEC’s ability to respond to a significant price rally will be hampered by the continued mismatch between OPEC’s predominantly sour crude oil and the predominance of low-sulfur petroleum products in the overall demand for oil. OPEC’s market influence is blunt.
4. Coming out of the economic downturn, there is still ample refining capacity and refining capacity utilization rates are historically low. Over the next two years, these utilization rates will go up, but there will still be significant spare capacity in the global refining sector.
5. Over the next two years, in a departure from the recent past, light, sweet crude oil production will rise by roughly 800,000 b/d in 2010 and 2011. This growth will temper price spikes in the critical WTI and Brent markets.
6. Even with a weak Europe, slow recovery in the U.S., and sober assumptions on China, a double dip recession is almost impossible absent an unforeseen exogenous event.
These six supply/demand fundamentals form the basis of the sustainable price range of the next two years.
BREAK OUT FROM THE SUSTAINABLE PRICE RANGE
There is potential to break out of the sustainable price range. Furthermore, there is more potential to break out on the upside than the downside. The most likely development to cause a significant increase in prices is a supply disruption, or even the expectation of a disruption. But, as mentioned above, some countries in OPEC have the ability to replace barrels. Obviously a disruption to Saudi production would be a game-changing event.
There is less potential for a break out below the range. Military conflict, natural disaster or terrorist event could reduce oil demand in a region, but chances are that the perceived threat to oil flows would outweigh the demand impact from the perspective of prices.
Another potential development that could encourage a break out to the upside is if oil demand surges beyond expectations in the next two years. Some forecasters are anticipating a slightly faster recovery, but ESAI’s projections are not overly conservative, therefore, it is unlikely that a demand “surge” would be dramatically higher than the projections presented.
In sum, there is a supply-side risk premium in oil prices that forces the sustainable price range to begin at non-OPEC marginal production cost and extend higher. But there is added risk of a break out above the upper end of the range due to the fact it is generally harder to sustain supply than sustain demand. This is a reality that stems from growing populations and rising income in developing countries in the Middle East, Asia and Latin America. This rising tide trumps the impact of weaker demand due to environmental policies and falling populations in mature economies.
ROLE OF FINANCIAL TRADE IN OIL
It has become clear over the last decade that oil is not just a physical good. It is also a capital market asset. As a result, the buying and selling of paper barrels of oil, as reported in the futures market (and unreported in the OTC markets), influences the price of physical barrels sold in the spot market by creating instant price discovery.
As much as investment banks and financial institutions, that buy and sell paper barrels, may claim to have an oil price view based on a “fundamentals” model, there is no doubt that their trading activity is based on perceptions not only of oil markets but also of equity, currency and broader commodity markets. As a result, their activity ties the oil market and oil pricing to much larger and faster moving markets and much more closely to the signals of the broader economy. Sometimes these “other” markets are the dog wagging the oil market tail.
More broadly, the trading and investment community are not looking for an equilibrium price. They test the sustainable price and want to anticipate the break out. As such, financial traders in the oil markets are comfortable with a risk premium in the oil price and repeatedly look for changes in the size of the premium. This is why, for much of the last decade, oil prices have seemed higher than fundamentals would dictate. This was especially the case in the 2004-2007 period when capacity constraints all through the supply chain inflated the risk premium and encouraged price rallies.
Today that premium is smaller and less volatile because the recession has eliminated much of the capacity constraints. Even so, the immutable threat of a supply disruption keeps a premium on prices, and will keep the financial community looking for an upside to oil prices.
(For more info from ESAI, visit www.esai.com)