Why Black Gold’s Low Prices Won’t Last Long

Attempting to forecast the oil price is a mug’s game. But that hasn’t stopped me in the past (ahem!) The reality is that crude is so important to modern life, and the path of the global economy, that for all the pitfalls of prediction, any serious economist needs to have a view on the future cost of the black stuff. Pivotal not just in terms of energy and transport, but also the manufacture of vital inputs from polymers to fertilizers, the dollar oil price is perhaps the world’s single most important economic variable.

My view is that the current price dip is temporary, partly illusory and that oil is now heavily over-sold, having fallen way below its fundamental value. As such, I’d venture that, in the absence of a 2008-style systemic meltdown on global markets, $100-a-barrel oil will return by the middle of 2015.

I’d also say – and I know this won’t be popular but here goes – that against the temporary boost that cheaper oil provides crude importers like America and the UK must be set a significant future cost. While cheaper oil feels good, acting like a tax cut for producers (and consumers if lower costs are passed on), it seriously curtails investment in future crude production. In other words, a period of low oil prices can create the conditions for a pretty sharp upswing. That’s especially true today, given that a relatively high share of the recent increase in global oil supply has come from relatively expensive “non-conventional” sources such as tar sands, ultra-deep water and tight “shale” oil.

From late 2010 until August this year, Brent crude traded within a relatively narrow range, averaging close to $110 per barrel. In each of the three years from 2011 to 2013 inclusive, the average crude price has been in triple-digit dollars. It won’t be far short in 2014 either, seeing as oil stayed well above $100 during the first eight months of this year and was just shy on average during September.

Over the last couple of months, though, crude prices have fallen by well over 30pc. From a high of $115, oil dipped below $72 last week, a four-year low, after the Opec exporters’ cartel – in particular Saudi Arabia – decided not to bolster prices by cutting their production quota from 30m barrels daily. Prices fell 5pc on Thursday alone, the day Opec announced that decision at the end of its annual Vienna summit.

Some commentators of a conspiratorial disposition suggest the Saudis are colluding with America, keeping oil prices low in a joint bid to damage their respective enemies, Russia and Iran. I would politely suggest this is hokum. Yes, cheaper oil suits America because, despite all the hype surrounding increased domestic production, the US remains the world’s biggest energy importer by far, still reliant on other countries for a net 9m barrels a day – amounting to over 10pc of total global production. And there’s certainly no love lost these days between the US and Russia.

It should be remembered, though, that relations between Riyadh and Washington are also extremely strained, not least due to American overtures to cooperate with Iran in the battle against Islamic State and US support for Qatar – a key backer of the Muslim Brotherhood, whom the Saudis detest. Once a key feature of post-War geopolitics, the US-Saudi axis is now seriously bent out of shape.

Remember, too, that while the Saudis are powerful within Opec, the likes of Venezuela and Iran are also influential. Clearly, the Saudis have managed to convince recalcitrant members to bite their tongues and accept that the 30m quota remains in tact. But it’s absurd to think that Riyadh could persuade other, far poorer members to keep prices low in order to please America – even if the Saudis wanted to, which they don’t.

Opec agreed what it agreed in Vienna for one reason only – to suppress prices in order to squeeze US shale producers, many of whom have high production costs and are shouldering lots of debt. The Saudis won the argument that the US shale boom must be countered by undermining the profitability of North American producers, curtailing current US production and future investment. At $70 oil, an awful lot of shale producers, particularly relatively small outfits that have driven much of the increase in US production from 7.5m barrels daily to 10m over the last four years, won’t be able to operate. Many of them will default on their borrowings, potentially dealing a serious blow to America’s “shale revolution”.

Opec Secretary General Abdullah al-Badri basically admitted in Vienna that his members were now engaged in a battle to defend their current one-third share of global oil markets. Asked at a press conference how Opec would respond to rising US oil output, he said: “We answered. We kept the same level of production. That is our answer”.

The main reason that the dollar price of oil has fallen so sharply in recent months has nothing to do with US-Saudi conspiring and an awful lot to do with Janet Yellen. At the end of October, the Chairman of the Federal announced that the US is to end its latest bond-buying programme, otherwise known as quantitative easing.

Since then the dollar has rallied on the strength of less virtual money-printing. The passing of the QE baton back to Japan, with the Eurozone soon to follow, has also helped drive the greenback to a near seven-year high against the yen and the single currency to an 18-month dollar low.

Oil is priced in dollars. All the major Opec producers peg their currencies to the dollar. Given that, when the dollar rises, all other things being equal, the price of oil falls. This is an axiomatic truth.

Having said that, I accept that we’ve recently seen higher Libyan production and also rising oil output from Iraq – both of which have contributed to lower prices. Also important is the fact that, earlier this autumn, the International Energy Agency cut its oil demand forecast for 2015.

Why, then, do I think that oil prices will bounce back next year – and remain relatively elevated in the medium-to-long term? One reason is that over two-thirds of the 12m-barrel rise in daily global oil production over the last decade has come from “unconventional” sources. While conventional crude costs up to $60 per barrel to produce, unconventional production generally absorbs $80-$100. So lower prices make some current production uneconomic and deter investment in future capacity – sowing the seeds of an upcoming price rise.

At the same time, the fundamental trends still point to expensive energy. The big populous emerging markets, while they’ve slowed down in recent months, are still consuming more than half of total crude output. They’re the reason why oil consumption has outstripped production for years – by over 4m barrels a day last year, and 3.7m the year before, with the shortfall coming from reserves.

Note, also, that the IEA didn’t “cut” its demand forecast for next year, as many newspaper headlines suggested. It actually said that oil demand would merely rise more slowly in 2015 than previously forecast, with total consumption growing by 1.1m to 92.4m barrels daily next year, rather than to 92.7m. That still amount to a 20pc increase in oil demand in not much more than a decade. The global crude industry meanwhile struggles to keep up, as it’s increasingly forced to tap more and more expensive unconventional oil.

The recent fall in the oil price is spectacular – and, if we’re lucky, motorists may even see a decent drop in petrol prices. But, unfortunately, it’s likely to be short-lived.

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