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Whither Oil Prices?

 4 min read / 

The previous OPEC summit in June ended on a very positive note.

“Right now, we have a very comfortable crude oil price, the market is stable and OPEC is producing 30m b/d of crude, more or less. The consumers are getting their sup- plies and the producers a good price. Everybody is happy”

-OPEC Secretary-General Abdalla Salem El-Badri

June, however, was a completely different context: Brent Crude was at $105/barrel and the world economy was supposed to grow 3.4% in 2014. As of November 25, Brent has stumbled to $78/barrel and economic growth at 3.4% appears increasingly infeasible given the European Union’s continued growth woes, Japan’s surprise economic contraction and China’s slowed pace. The consequence of slow economic growth is that it decreases demand for oil. Adding to OPEC’s series of misfortunes is the rise of US Shale (tight) oil and less importantly, substitution of natural and shale gas. From less than 1 million barrels/day in 2010, tight oil production increased to more than 3.5 million barrels/day in the second half of 2014. This has diminished American import of oil. This was the first year where the US did not import oil from Nigeria since 1973. Further, the substitution, though imperfect, of natural gas for the purposes of power generation, particularly in the US transport sector, has reduced demand for Brent Crude.

However, Saudi Arabia, the world’s leading oil producer, has not  responded to the 30% fall in prices since September. This has puzzled many observers and led to various theorizations. Most point to competitive inclinations, stating that Saudi Arabia is hoping to make redundant US Shale oil. Approximately 50% of tight oil producers in the US, yet to gain from economies of scale, cannot cover fixed costs below $75/barrel. Healthy Balance of Payments on the other hand, allows Saudi Arabia to withstand low oil prices in the near term. The burning question remains: where are oil prices headed? The consensus among analysts was that OPEC would cut output by approximately 1 million barrels/day to buoy price levels, a prediction that was not borne out. Why was there a collective failure to act?

The calls of Venezuela and Iran, requiring oil to be priced at least $130/barrel to maintain Balance of Payments this year, went unheard. Eventually the dictates of Saudi Arabia, the de facto leader of OPEC, emerged victorious and the status quo remained. This action can be explained by two factors: the desire to squeeze Shale production and faith in future demand. Allowing low prices is a direct challenge to US shale oil producers; as one analyst states, “It’s just good business”. Analysts estimates of a price floor range from $50-$60 and expect them to remain within this range at least until mid 2015. If this materializes, unprofitable Shale producers will be forced to shut down and total American supply will reduce. Such conditions, as opposed to now, might be more fertile grounds for reducing production and pushing prices upwards.

Saudi faith in future oil demand is very optimistic and can be discerned from their future estimates. They have only reduced their forecast for demand in 2035 by 0.5 million barrels/day and expect oil demand to be near 111 million barrels/day. Specifically, much of their faith rests on heightened Asian demand. Optimism, however, is always a risky proposition. Rumours of another stimulus from the Chinese Central Bank indicate concerns for decreasing aggregate demand.

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