Why Oil Prices Have Scraped The Bottom Of The Barrel

Only a fool or a liar claims to know where the oil price is going. I like to think I’m neither – although some may disagree. While predicting the future path of crude is almost impossible, the oil price remains the most important economic variable on earth.

So, despite the pitfalls, any self-respecting economist needs to take a view. Mine is that oil is priced some way below its fundamental value, and has lately been artificially deflated by a soaring dollar and excessive fears the Chinese economy is about to implode, based on the dramatic volatility of its relatively small but highly visible stock market.

To that, we might add a sizeable dose of wishful thinking about the future growth of US shale production and “Iran quickly coming properly back on stream” following a sanctions reprieve which, given the vagaries of US politics, may yet not happen.

The likelihood in my view is that, over the coming year, the trajectory of crude will rise – and, once the dollar falls back and shale production truly flounders, prices could go up rather sharply. Unless, that is, none of this happens and oil stays roughly where it is, or keeps heading downward!

Predicting the oil-price path is so difficult because both demand and supply are themselves subject to countless unfathomable factors. The speed of global growth – not least the US and China, by far the world’s two biggest oil importers – is the most important driver of total oil use. Will the supply side then develop as predicted, or exhibit unexpected production surges? Could it, alternatively, be hit by political unrest in the likes of Nigeria, Venezuela or Iraq? All three countries pump well over 2m barrels daily, more than enough – if such supplies are threatened – to hike the price of the 92m barrels we currently use each day.

Estimates of total global oil inventories vary widely, depending on whom you ask – but that doesn’t stop such data from moving the market. Then there are the speculative pressures, based on rumor, fear and innuendo that often send oil markets haywire.

There’s also ample scope, of course, for unrest in the Middle East to send oil soaring. Any systemic meltdown on global markets, another “Lehman moment”, would conversely see the crude price collapse. I mention all this only to stress, in an outbreak of honesty too rarely displayed by economists, that when it comes to oil prices twelve weeks or twelve months hence, no-one really knows anything. Yet every economic growth estimate, in every country, is affected profoundly by one’s view on the future price of oil.

What we do know is that Brent crude was over $100 a barrel as recently as June 2014. Oil has fallen almost to $40 and is currently around $46. Over recent weeks, the market has been particularly volatile, with crude rising over 10pc in a single day at the end of August, its biggest increase since late 2008. Going well over $50, crude spiked on the combination of an upward revision to US growth and the outage of two pipelines across the Nigerian delta. Such erratic prices partly reflect thin summer trading volumes. But they’re also explained by the general confusion, and lack of consensus, on where the oil market is headed.

My sense that prices will soon go up is based on three main observations, the first of which is US output. Since 2009, US shale production has grown from almost nothing to 4pc of global output. That’s driven total American supply from 7.3m barrels daily to 11.6m last year – approaching peak US production of the mid-1970s. When oil goes below $70, though, and certainly when it languishes under $50 as now, almost all shale producers lose money. That particularly applies to the small, high-cost outfits that have driven America’s recent production rise.

So production stops, as does investment in future wells – and that’s now happening on a major scale. Last week, America’s government-backed Energy Information Agency said domestic production would be 9.2m in 2015 – some 20pc lower than last year. The EIA predicts a further drop to 8.8m barrels in 2016. That’s because low oil prices have driven down total US rigs in operation from over 1,600 a year ago to less than 700 today.

The US shale outfits, for all their determination, admirable efficiency drives and fighting talk, are suffering badly. While some have hedged their price exposure, most are unhedged and heavily indebted. As shale wells deplete far more quickly than conventional wells, and need constant re-drilling, operating at these prices requires ever more debt capital, which is currently scarce.

That’s why the US shale industry last week reported a cash outflow of over $30bn during the first half of 2015, as lower oil prices forced a spate of bankruptcies and restructurings. America’s shale revolution has indeed caused a production surge but the revenues generated, for all the hype, have never got close to covering related capital spending. And now US production is falling fast – with the lost volumes large enough to help push global prices back up. America’s shale producers will recover and come again, no question, but only when we’re back at $80-$90 a barrel.

My second – related – observation concerns Saudi Arabia. American’s recent production rise didn’t go unnoticed by the Saudi-led Opec exporters’ cartel. Last November, at a time of souring relations with Washington, Riyadh decided that Opec wouldn’t cut its export quota in the face of falling prices. The goal was to drive prices even lower, so knocking upstart US shale producers out of the market.

So when will Opec change its mind, and cut production once again? That’s when the oil market will truly turn, when traders believe the body controlling a third of global oil supplies has decided enough is enough. I think that moment could come soon.

Riyadh has been determined to keep prices low enough for long enough to achieve its unstated but obvious aim. Had Saudi not succeeded in imposing real pain on US shale producers, that could undermine its clout later, when Opec wants to resume its traditional role of keeping prices high.

The Saudi government’s budget, meanwhile, commits it to spending $296bn in 2015 – much of it on lavish welfare payments that keep political unrest in check. Riyadh’s break-even oil price is over $90 a barrel. With oil near $40, the Saudis are bleeding red ink, running a deficit of over $500m a day.

That’s why the Riyadh now faces a budget deficit approaching 20pc of GDP, its reserves having plunged from $774bn in December to $664bn last month – a 14pc drop. The Saudis, nerves shredded and their oil ministry in turmoil, now desperately need an excuse – to return to normality, cut production and send oil prices back up. The US production drop announced last week is pretty seismic – and could be the excuse that Riyadh needs.

My final thought relates to the dollar. Last autumn, the Federal Reserve announced that the US will rein-in quantitative easing. Since then, the dollar has surged – which, in turn, has driven down oil, seeing as it’s priced in dollars.

The US recovery is so shaky, though, that American QE could well make a comeback. And the Fed, despite its rhetoric, is unlikely to raise rates anytime soon. As the markets digest this reality over the coming months, and the dollar falls, oil subsequently goes up. But, as I said, no-one really knows anything. We’re talking about oil, after all.

http://www.telegraph.co.uk/finance/oilprices/11859148/Why-oil-prices-have-scraped-the-bottom-of-the-barrel.html

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