- Oil prices down almost 30% on oversupply, stronger dollar and lower expected demand
- All eyes on OPEC for oil price direction in 2015 in supply-driven market
- Lower oil prices provide unexpected support for global growth
Unexpected (but predictable) sharp fall in oil prices
Oil prices have plunged by almost 30% since the summer (Figure 1). Though the timing and speed of this enormous drop took many by surprise, a downward adjustment of this magnitude had long been on the cards. Some time, various arguments – see below – had pointed to a downward correction of oil prices. However, the price decline failed to materialise due to geopolitical tensions and the attendant fear that oil production would be hit, as well as the weak dollar and upbeat expectations for economic recovery (which would spur demand for oil). These factors initially conspired to keep oil prices hovering within a bandwidth of roughly USD 105-115/barrel. But things changed this summer, when several downward driving forces affecting oil prices simultaneously fell into place:
- The oil supply accelerated unexpectedly quickly, both from OPEC and non-OPEC countries. Geopolitical tensions proved to have no effect on oil production. And the risk premium decreased further.
- The high demand expectations for oil were revised down in response to disappointing economic data from China, Europe (particularly Germany) and the US.
- The dollar appreciated in value due to monetary policy divergences between the US and Europe.
- The final argument was the announced price cut for US customers of Saudi oil, signalling that OPEC may be focusing on beating competition from the US and retaining market share.
The extent of the price drop seems out of line with the trend of the past two years. However, a glance at a slightly longer-term chart reveals that a decline in the USD 75-80/barrel bandwidth is not unusual (Figure 2). USD 80 is seen as a key level as it is assumed to be equivalent to the average cost price of many oil-producing countries. Moreover, the fiscal budget of Saudi Arabia is now based on an oil price of about USD 80/barrel. The rapid recent price drop towards this level is consistent with this pattern.
Short-term focus on OPEC
OPEC is due to meet on 27 November to discuss the developments in the oil market and possible actions. During this scheduled meeting, the OPEC production quota for 2015 will also be set. Given that the oil price has fallen rapidly, the market is looking to the only party who has so far proved to be a stabilising factor: Saudi Arabia. The big question is whether Saudi Arabia will once again be prepared to assume the role of ‘swing producer’. The market widely expects Saudi Arabia, and hence OPEC as a whole, to lower production in support of the oil price.
In our view, however, OPEC is more likely to leave the production quota unchanged and maintain the agreed output level at 30 million barrels per day, while relying on a form of forward guidance to support oil prices. In the past, this instrument was mainly used by central banks, such as the ECB and the Fed, to steer the market in a particular direction. All in all, OPEC has several good reasons to shy away from official output cuts:
- To start with, local unrest is causing severe production swings in some OPEC countries. Libya is a good example: production increased from about 200,000 barrels per day in May to almost 800,000 in September. Whether this level is sustainable remains to be seen. OPEC will take these output volatilities into account.
- As is evident from Figure 3, oil production can be cut within the current arrangements. Over the past years, production has exceeded the agreed target, despite all the unrest in the region. A lower target will therefore not necessarily lead to less oil in the market.
- Maintaining the quota can create scope for other OPEC countries to notch up production in line with the arrangements/ambitions at the expense of Saudi oil production.
- In addition, OPEC will not stand back and allow increased demand for oil in Asia to be entirely absorbed by non-OPEC oil. Asia is shaping up to be the only true growth market for oil, now that the US is steadily reducing its OPEC oil purchases and demand from Europe looks set to fall further in the coming years.
- Finally, Saudi Arabia recently reduced the price for US customers in order to remain competitive against locally produced oil. This put extra pressure on oil prices and seems to suggest that Saudi Arabia has no interest in cutting production. This strategy is at odds with the probable effect on prices of an announced production cut.
Going forward, the USD 75-80/barrel bandwidth is likely to be tested, and an even lower price cannot be ruled out in the short term. Even so, this effect would appear to be only temporary. We expect an upward price correction before the end of the year, driven by several factors: 1) unreliable oil production/exports from countries with internal unrest, such as Libya, 2) the removal of uncertainties over the OPEC production quota for 2015, 3) the postponement of projects that are not commercially viable at a price under USD 80/barrel, and finally 4) profit-taking and/or closing of speculative short positions before the end of the year.
Economic consequences of lower oil prices
Even assuming that oil prices recover to a certain extent, the average oil price will remain substantially lower than in the past years. This will have major consequences, both in macroeconomic terms and for individual companies, particularly international oil concerns. At a global macroeconomic level, lower oil prices are generally good news. A lower oil price brings about a shift in wealth from oil exporters to oil importers. Oil-consuming countries are generally more prepared to spend the ‘additional’ capital. The rule of thumb is that a USD 10/barrel price drop gives the global economy an extra growth impulse of some 0.3%, implying that the recent USD 30/barrel price fall will contribute almost 1% to economic growth – a welcome boost for the fragile global economy. But can the oil producing countries cope with this shift in wealth? After all, they need sufficient oil revenues to invest in the energy sector and maintain oil production at the required level as well as to continue meeting their social and fiscal obligations. For this reason, oil prices must, and will, stabilise. Finding a new balance will inevitably go hand in hand with oil price volatility over the coming years. During this quest, we expect the average oil price to continue edging lower year-on-year. See Table 1 for our oil price outlook.
Consequences of low oil price for oil companies
Questions have been raised as to whether the oil price is a key driver of the profits of international oil companies (IOCs). Companies like BP, Total and ConocoPhillips recently announced lower-than-expected third-quarter figures, citing low oil prices as the main reason for their disappointing results. Nevertheless, other oil companies such as Royal Dutch Shell, ExxonMobil and Chevron actually posted higher results, despite the lower oil prices. This can partly be explained by their higher revenues from refinery activities, the costs of which have fallen thanks to the lower prices. The conclusion, therefore, is that oil prices most definitely have a bearing on the profits of IOCs.
However, cash flow expectations are often more important than reported profits. Cash flows are not only determined by reported profits on existing assets (oil and gas price times produced/sold volumes minus the cost price of the extraction of oil and gas) but also by the costs (operating expenses and investments) incurred to develop new fields. Regarding the market valuation of the large IOCs, the main priority of their shareholders is to secure a reliable dividend. To pay out this dividend (and maintain a stable balance sheet), the IOC must at least generate sufficient operational cash flow to not only make the required future investments, but meet their dividend obligations.
If the oil price falls, IOCs must adjust their cash flow in line with the falling selling prices. They will initially put a brake on this by reining in their expenditures, particularly in relation to future projects that are expected to involve high initial costs whilst only contributing to the result after many years. They will also seek to take advantage of any scope to negotiate lower prices with subcontractors. New contracts with subcontractors are already a quarter cheaper than one year ago.