Oil prices: the ups and the downs

Back in October, we examined the rise in oil prices. We said that, ‘With Brent
crude currently at around $85 per barrel, some commentators are predicting the
price could reach $100. At the beginning of the year, the price was $67 per barrel;
in June last year it was $44. In January 2016, it reached a low of $26.’ In that blog
we looked at the causes on both the demand and supply sides of the oil market. On
the demand side, the world economy had been growing relatively strongly. On the
supply side there had been increasing constraints, such as sanctions on Iran, the
turmoil in Venezuela and the failure of shale oil output to expand as much as had
been anticipated.

But what a difference a few weeks can make!

Brent crude prices have fallen from $86 per barrel in early October to just over $50
by the end of the year – a fall of 41 per cent. (Click here for a PowerPoint of the
chart.) Explanations can again be found on both the demand and supply sides.

On the demand side, global growth is falling and there is concern about a possible
recession (see the blog: Is the USA heading for recession?). The Bloomberg
article below reports that all three main agencies concerned with the oil market –
the U.S. Energy Information Administration, the Paris-based International Energy
Agency and OPEC – have trimmed their oil demand growth forecasts for 2019.
With lower expected demand, oil companies are beginning to run down stocks and
thus require to purchase less crude oil.

Fracking (Source: US Bureau of Land Management Environmental Assessment,

public domain image)
On the supply side, US shale output has grown rapidly in recent weeks and US
output has now reached a record level of 11.7 million barrels per day (mbpd), up
from 10.0 mbpd in January 2018, 8.8 mbpd in January 2017 and 5.4 mbpd in
January 2010. The USA is now the world’s biggest oil producer, with Russia
producing around 11.4 mpbd and Saudi Arabia around 11.1 mpbd.

Total world supply by the end of 2018 of around 102 mbpd is some 2.5 mbpd
higher than expected at the beginning of 2018 and around 0.5 mbpd greater than
consumption at current prices (the remainder going into storage).

So will oil prices continue to fall? Most analysts expect them to rise somewhat in
the near future. Markets may have overcorrected to the gloomy news about global
growth. On the supply side, global oil production fell in December by 0.53 mbpd.
In addition OPEC and Russia have signed an accord to reduce their joint
production by 1.2 mbpd starting this month (January). What is more, US sanctions
on Iran have continued to curb its oil exports.
But whatever happens to global growth and oil production, the future price will
continue to reflect demand and supply. The difficulty for forecasters is in
predicting just what the levels of demand and supply will be in these uncertain
times.

Rising oil prices – winners and losers

Oil prices have been rising in recent weeks. With Brent crude currently at around
$85 per barrel, some commentators are predicting the price could reach $100. At
the beginning of the year, the price was $67 per barrel; in June last year it was $44.
In January 2016, it reached a low of $26. But what has caused the price to
increase?

On the demand side, the world economy has been growing relatively strongly.
Over the past three years, global growth has averaged 3.5%. This has helped to
offset the effects of more energy efficient technologies and the gradual shift away
from oil to alternative sources of energy.

On the supply side, there have been growing constraints.

The predicted resurgence of shale oil production, after falls in both output and
investment when oil prices were low in 2016, has failed to materialise as much as
expected. The reason is that pipeline capacity is limited and there is very
little scope for transporting more oil from the major US producing area –
the Permian basin in West Texas and SE New Mexico. There are similar pipeline
capacity constraints from Canadian shale fields. The problem is compounded by
shortages of labour and various inputs.

But perhaps the most serious supply-side issue is the renewed sanctions on Iranian
oil exports imposed by the Trump administration, due to come into force on 4
November. The USA is also putting pressure on other countries not to buy Iranian
oil. Iran is the world’s third largest oil exporter.

Also, there has

been continuing
turmoil in the
Venezuelan
economy, where
inflation is currently
around 500 000 per
cent and is expected
to reach 1 million per
cent by the end of the
year. Consequently,
the country’s oil
output is down.
Production has fallen
by more than a third
since 2016.
Venezuela was the world’s third largest oil producer.

Winners and losers from high oil prices

The main gainers from high oil prices are the oil producing countries, such as
Russia and Saudi Arabia. It will also encourage investment in oil exploration and
new oil wells, and could help countries, such as Colombia, with potential that is
considered underexploited. However, given that the main problem is a lack of
supply, rather than a surge in demand, the gains will be more limited for those
countries, such as the USA and Canada, suffering from supply constraints. Clearly
there will be no gain for Iran.

In terms of losers, higher oil prices

are likely to dampen global growth.
If the oil price reaches $100 per
barrel, global growth could be
around 0.2 percentage points lower
than had previously been forecast.
In its latest World Economic
Outlook, published on 8 October,
the IMF has already downgraded
its forecast growth for 2018 and
2019 to 3.7% from the 3.9% it
forecast six months ago – and this
forecast is based on the assumption
that oil prices will be $69.38 a barrel in 2018 and $68.76 a barrel in 2019.
Clearly, the negative effect will be greater, the larger a country’s imports are as a
percentage of its GDP. Countries that are particularly vulnerable to higher oil
prices are the eurozone, Japan, China, India and most other Asian economies.
Lower growth in these countries could have significant knock-on effects on other
countries.

Consumers in advanced oil-importing countries would face higher fuel costs,

accounting for an additional 0.3 per cent of household spending. Inflation could
rise by as much as 1 percentage point.

The size of the effects depends on just how much oil prices rise and for how long.
This depends on various demand- and supply-side factors, not least of which in the
short term is speculation. Crucially, global political events, and especially US
policies, will be the major driving factor in what happens.

OPEC’s juggling act

OPEC, for some time, was struggling to

control oil prices. Faced with
competition from the fracking of shale
oil in the USA, from oil sands in Canada
and from deep water and conventional
production by non-OPEC producers, its
market power had diminished. OPEC
now accounts for only around 40% of
world oil production. How could a
‘cartel’ operate under such conditions?

One solution was attempted in 2014 and

2015. Faced with plunging oil prices which resulted largely from the huge increase
in the supply of shale oil, OPEC refused to cut its output and even increased it
slightly. The aim was to keep prices low and to drive down investment in
alternative sources, especially in shale oil wells, many of which would not be
profitable in the long term at such prices.

In late 2016, OPEC changed tack. It introduced its first cut in production since
2008. In September it introduced a new quota for its members that would cut
OPEC production by 1.2 million barrels per day. At the time, Brent crude oil price
was around $46 per barrel.

In December 2016, it also negotiated an agreement with non-OPEC producers, and

most significantly Russia, that they would also cut production, giving a total cut of
1.8 million barrels per day. This amounted to around 2% of global production. In
March 2017, it was agreed to extend the cuts for the rest of the year and in
November 2017 it was agreed to extend them until the end of 2018.

With stronger global economic growth in 2017 and into 2018 resulting in a growth
in demand for oil, and with OPEC and Russia cutting back production, oil prices
rose rapidly again (see chart: click here for a PowerPoint). By January 2018, the
Brent crude price had risen to around $70 per barrel.

Low oil prices had had the effect of cutting investment in shale oil wells and other
sources and reducing production from those existing ones which were now
unprofitable. The question being asked today is to what extent oil production from
the USA, Canada, the North Sea, etc. will increase now that oil is trading at around
$70 per barrel – a price, if sustained, that would make investment in many shale
and other sources profitable again, especially as costs of extracting shale oil is
falling as fracking technology improves. US production since mid-2016 has
already risen by 16% to nearly 10 million barrels per day. Costs are also falling for
oil sand and deep water extraction.

In late January 2018, Saudi Arabia claimed that co-operation between oil
producers to limit production would continue beyond 2018. Shale oil producers in
the USA are likely to be cheered by this news – unless, that is, Saudi Arabia and
the other OPEC and non-OPEC countries party to the agreement change their
minds.