Energy Monitor December – Where is the bottom?

by: Hans van Cleef

Energy-Monitor - 15 december 2014 - Where is the bottom?.pdf ()

The drop continues

Oil prices have been under heavy pressure for several months now. The decline started in the summer, accelerated in September & October and again gained momentum in November, after an OPEC meeting, where supply levels were left unchanged. As a result, Brent oil prices have dropped by more than 45%. The slide was initially triggered by two developments: disappointing economic data releases in the US, Europe and China that hurt demand expectations and oversupply, which was reconfirmed by OPEC and appears to be more than enough to meet an increase in global demand. OPEC’s decision to not cut its oil production quota added pressure to oil prices. While some oil suppliers, such as Venezuela and Iran, hinted at a cut in oil production to halt the slide in prices, other OPEC members, and, in particular, Saudi Arabia, did not agree. OPEC kept its quota unchanged at 30 million barrels per day (mb/d). Moreover, in OPEC’s monthly report, it indicated that it had revised downward its 2015 forecast for OPEC oil demand. As a result, (Brent) oil prices dropped even further and are currently trading below USD 65/bbl. WTI is trading several dollars lower.

Now what?

We have received many questions about how much further oil prices can fall. Our answer on the outlook for oil prices depends on the time horizon.

Near term: stabilization and rebound

In the near term, downside risks are significant. The market is strongly reacting to negative oil price drivers, while ignoring more positive news. We do see, however the first signs of investors, hedge funds and oil traders searching for reasons to buy. There are also more reports of oil project delays, as lower oil prices reduce the profitability of some projects. Some oil producing companies, especially smaller US companies, face financial problems due to their oil production activities. As result, the risk of their default is increasing. Some of these companies may be taken over by more liquid, larger oil companies, but a portion will not survive the shake-out. As a result, we believe that the expected oversupply in 2015 will be reduced.

When OPEC lowered its estimate of expected demand for OPEC oil in 2015, the media appeared to ignore that the forecast for global oil demand was also revised lower and that non-OPEC supply was expected to be larger than earlier expected. Based on secondary sources, the latest OPEC report signals that OPEC oil production dropped to 30.05 mb/d in November. If confirmed, it proves that OPEC actually did lower its production after all (Figure 3). Oil prices have not yet reacted to this information.

We believe that the downside risks for oil prices remain very large. Nevertheless, we think that the drop in oil prices went too fast and too far. We expect that prices will stabilize and start to rebound within several weeks. Market volatility, however, complicates short-term forecasts, especially given the declining market liquidity ahead of the holiday season. This may lead to unexpected and large swings in oil prices in a single day, without a clear or identifiable reason.

Medium term: production levels are key

In 2015, the effects of the strong price declines will become much more visible. Signs that production will be affected, such as oil project delays and problems with financing, will increase is prices do not rise. In the first half of the 2015, there will be more clarity regarding whether OPEC will stick to its production quota. It is already a production cut when compared to 2014 production. The current pressure on oil prices is mainly based on the market expectations of strong oil production in the coming months, in combination with expected disappointing oil demand. Several large oil-producing countries, however, have the reputation of missing their production quotas. Such behavior in Iraq, Iran, Libya and Brazil, for example, could result in adjustments to expected oil oversupply. In addition, the accelerating global economic recovery that we expect could result in stronger oil demand than the market is pricing in.

We believe that the average Brent oil prices should be between USD 80/bbl and USD 90/bbl in 2015. Due to the current low oil price, we revised some of our quarterly oil price forecasts to better reflect current markets (Table 1). We are not, however, revising our 2015/2016 year-forecasts. We stand by our view that, while there are risks in the near-term that prices will decline, we believe that prices have dropped too far and too fast. We believe it is likely that there will be an upward price correction in the coming weeks. We expect oil prices will be in the range of USD 80-90/bbl in 2015. This is significantly higher than the current spot price, but also significantly lower than the 2014 average price of around USD 100/bbl.

Long-term view: rebound expected

What is not reflected in recent media updates are the possible effects of lower oil prices in the long term, including a decline in investment in the energy (oil & gas) infrastructure in large oil & gas producing countries. The economic sanctions against Russia and Iran have worsened this situation. The low oil price will also start to bite in the nearer term. The economies of some oil-producing countries (Russia, Iraq, Iran, US, Brazil, Canada, for example) will be hurt by lower prices. Investment in new, but also existing, energy infrastructure will therefore fall under further pressure. This could have serious effects on oil production in the longer term. The first big effects will, however, only be seen in three to five years. From the oil market’s perspective, a price rebound to a level which is comfortable for both consumers and producers is desirable. No one will benefit from oil shortages.