Will oil prices stabilize around $80?
Most commentators and oil analysts are convinced a further rise in prices is inevitable in the next few years as emerging market consumption grows and supplies increasingly come from more costly and technically challenging sources such as ultra-deepwater.
While there are disagreements about the extent and the timing of price changes, there is a remarkable degree of consensus about the direction: up. But the roller-coaster experience of the last five years should have taught forecasters to be much more cautious about extrapolating trends and assuming the future direction is obvious.
Price forecasts are notoriously unreliable. There are simply too many variables and too much uncertainty about the current state of the market let alone how supply and demand will evolve in future. The crucial role of expectations in price formation adds an element to “reflexivity” which is hard for forecasters to anticipate or model accurately.
Reflexivity is a concept attributed to billionaire financier George Soros, in which perceptions of market direction and market fundamentals influence one another.
Forecasters’ confidence prices can only increase in future seems misplaced. On closer inspection, many of the factors which make price rises seem inevitable are flawed or unpersuasive. At present there are no fundamental reasons oil prices must increase above the current level of around $80 per barrel in real terms (once inflation and exchange rate changes are taken into account). Nor is there any reason to expect a spike in prices similar to 2008.
Prices have remained stable in a relatively narrow range of $65-85 for more than 12 months. While prices are unlikely to stay at this level forever, there is no compelling reason to expect the next move to be higher than lower, or for the current trading range to break down in the short to medium term. Risks to the outlook appear balanced, as they should be if the market is discounting expectations properly.
In its November Oil Market Report (OMR), the International Energy Agency (IEA) attributed the spike in late 2007 and the first half of 2008 to a combination of factors — including strong demand growth; constrained supply; tight spare capacity; and a mismatch between crude oil supply, refining capacity and product specifications; as well as fears about peak oil and growing interest in commodities as an asset class.
While investor interest in commodities as an asset class remains high, none of the other factors is present at the moment:
(1) Product consumption in emerging markets continues to rise at an annual rate of more than 1 million barrels per day (bpd) but consumption in the advanced economies is subdued. In place of the strong synchronised growth at the end of a long global expansion that put so much upward pressure on commodity prices in 2007-2008, the world economy is now experiencing an uneven recovery that has left demand in the advanced economies well below its previous peak, creating near-term slack to absorb growth in Asia.
(2) Supply has been healthy, with upside surprises in both non-OPEC oil production and output of natural gas liquids (NGLs) by OPEC members (which are not constrained by the organisation’s production limits). Some of those surprises may not be repeatable, but there is still every reason to expect supply will grow strongly over the next 2-3 years.
Prices are half their 2008 peak, but still high in real terms. Cashflow is healthy and should be more than adequate to fund continued expansion in exploration and production activity. Drilling activity has bounced back and surpassed its previous peak. More importantly, the industry is starting to benefit from more than five years of high and rising prices, increasing the supply of trained engineers, equipment and infrastructure to sustain output growth.
(3) Global oil inventories and spare capacity are far more comfortable than they were in 2007-2008 and provide a robust cushion against supply or demand disruptions.
OPEC members have around 5 million barrels per day of idled production capacity, according to the U.S. Energy Information Administration, up from just 1 million in summer 2008. Forward demand cover stands around 60 days according to the IEA. Spare capacity and stocks are gradually being drawn down by the expansion, but should remain enough to buffer the system for at least another 1-2 years.
(4) Much of the physical tightness in 2007-2008 was not related to a general shortage of oil (let alone peak oil) but an acute shortfall in particular grades of low-sulphur crude in high demand by refiners in the United States and Western Europe as they were required to meet new, tougher standards for low-sulphur gasoline and diesel.
Demand for sweet crudes rose sharply, at the same time as their supply contracted because of violent disruption in Nigeria. There was never at any point a shortage of oil. But the marginal crude available to the market was heavy sour, and U.S. and European refineries had run out of desulphurisation capacity to process it to meet new product specifications, leading to intense competition for the sort of light sweet crude oils referenced by the major futures benchmarks.
The 2008 price crisis was less about peaking oil production than a poorly phased introduction of new environmental standards and a squeeze on refinery desulphurisation capacity. But the shift to low sulphur gasoline and diesel is now largely complete in North America and Western Europe. Much of the new crude production coming on-stream in 2011-2015 will be relatively light and sweet, improving the average quality of feedstock. Changing product specifications are unlikely to cause a repeat for the time being.
Major refiners expect markets for crude and refined products to remain well supplied for the next few years — matching the IEA’s medium-term outlook to 2015. It is possible to project a significant tightening in the supply-demand balance beyond the middle of the decade, if current demand trends continue and new sources of supply fail to keep pace — especially for middle distillates.
But these medium-term forecasts are surrounded by even greater uncertainty than their short-term brethren. In its budget predictions, the U.S. Congressional Budget Office (CBO) distinguishes between short-term “forecasts” (up to three years) and medium-term “projections” (beyond three years) which make no attempt to adjust for cyclical factors but just extrapolate long-term trends. CBO argues beyond three years it is simply too difficult to forecast the economic cycle and other factors affecting the budget accurately.
Medium-term oil projections should come with similar warnings. Five years is an eternity in the industry in terms of both demand and innovation. Oil forecasters should recall what happened in the natural gas industry, where the shale gas revolution completely changed the outlook for supply and prices in the space of 5 years.
It may be hard to remember now but in 2005 the Hirsch Report, prepared for the U.S. Department of Energy, warned previous optimism about gas supplies “turns out to have been misplaced” and “supply difficulties are almost certain for at least the remainder of the decade”.
“Gas production in the United States now appears to be in permanent decline”, according to the consensus view of the senior market analysts cited in the report. Hirsch urged policymakers to learn the lessons from “peak gas” and be ready to deal with the disruption caused by “peak oil”. Instead gas production surged as a result of the widespread application of hydraulic fracturing and exploitation of shale gas.
The point is that while we may “suspect” the oil market will be tight in 2015-2020, we don’t “know” it.
Long-term projections are little more than educated guesswork and almost certainly underestimate feedback effects on both supply responsiveness and the demand side.
Investors and analysts buying 2011-2012 oil futures, or even long-dated 2015-2017 futures to benefit from an eventual tightening in the market, could end up paying a lot of contango in the meantime while they wait for the uncertain prospect of a price spike.
In the short term there are simply no strong reasons to conclude oil prices must move significantly higher, rather than lower, once inflation and exchange rate changes are taken into account.