OPEC sings the same tune

by: Hans van Cleef

Over the past few days, oil prices have plunged at an accelerating pace to well below USD 75/barrel. The reason was OPEC’s decision to keep its production quota unchanged at 30 million barrels per day, while indicating that the market must seek its own equilibrium. Judging by the violent market reaction, there were evidently plenty of speculators anticipating a reduction of the production quota. All in all, the oil price sank almost 10% this week, bringing the total decline since the peak in June of this year to almost 40%.

The reaction in proper perspective

  • The key word that is widely forgotten in this debate is “structural”. Though oil prices have fallen sharply in the past months, the average oil price for 2014 is still well above USD 100/barrel. Countries and companies that finance oil projects do not base their decisions on daily prices, but on yearly averages. A lower oil price will therefore only become a real problem for investments if oil prices stabilise at the current lower level on a structural basis.
  • The speculations about a quota adjustment were mainly fed by pressure from two OPEC members, Venezuela and Iran, to cut output. Their economies are suffering severely from the lower oil prices. Iran in particular, like its competitor Russia, has been hard hit by this price slump. Sales were already under pressure from sanctions imposed earlier by the West. The only country that is free to significantly adjust production is Saudi Arabia, possibly together with Kuwait and the United Arab Emirates. Venezuela and Iran are currently marginal players.
  • The calls were for a reduction of 1 million barrels of oil per day. This is equal to 1.1% of global daily output. Interestingly, it is also equal to the surplus that OPEC itself produced in October: OPEC’s production in that month came to 31 million barrels per day.
  • Even if OPEC had cut production, this would immediately have raised the reserve capacity by the same volume. This reserve capacity can be added within a few weeks to the production capacity. Consequently, a reduction of the production quota would have been more likely to lead to a stable, and possibly even lower, oil price. After all, in the event of any new calamities or unrest in oil-producing countries, output could easily be stepped up again.

Now that the initial reaction is behind us, the market can stand back and review the new situation. I expect oil prices to undergo a technical upward correction soon. Again, I will mention my four most important reasons in no particular order:

Reasons for a near-term recovery

  • The OPEC meeting is over and the outcome is known. The market can once again focus on the facts of the oil market and shrug off the speculative factor, also known as the ‘Buy-the-Rumour-Sell-the-Fact’ phenomenon. The resulting profit-taking on speculative short positions will lend support to the oil price. Incidentally, the closing of speculative positions is an effect that becomes stronger as the end of the year draws nearer.
  • Given the current low level of oil prices, talk of oil production projects being postponed or even cancelled will grow louder. This will drive up prices.
  • Libyan oil production is extremely erratic, fluctuating somewhere between 0 and 1 million barrels per day. The unexpected strong output spike of the past three months is very probably unsustainable. I refer to the fresh outbreak of unrest in the country and the ensuing export restrictions. And indeed, this is another reason why OPEC will want to wait and see how the situation of lower oil prices unfolds over a longer period of time.
  • A lower oil price will give a boost to economic growth, as wealth will shift from the oil producer to the consumer. Roughly speaking, a USD 10/barrel fall in the oil price generates 0.3% extra global growth. In due course, extra growth translates into rising demand for oil, which will ultimately put a floor under prices.

At this stage I am not adjusting our oil price forecast and I still expect an average oil price of over USD 100/barrel for 2014. The USD 90/barrel forecast for the end of 2014 may be slightly too high. But – only a few days after such a strong movement – it is too early to make an accurate estimate of the year-end price.

The fundamentals have effectively remained unchanged. OPEC has firmly stressed its intention to produce 30 million barrels of oil per day during the first half of 2015. However, whether it sees this as a target or a ceiling remains unclear. If OPEC genuinely adheres to this quota, in the sense of ‘ceiling’, it has effectively announced a production cut after all (compared to the output of 31 million barrels per day in October).

And, as the facts show, there has been an oversupply of oil since 2012. This also explains why the annual average has already been falling for several years and will continue to decline. Accordingly, I foresee an average oil price of USD 90/barrel for 2015. This projection is based on an expected acceleration in the demand for oil driven by economic growth, mainly from emerging markets. However, this increased demand will be entirely absorbed by higher oil production in non-OPEC countries. Nevertheless, the ample production potential within OPEC, combined with the upward dollar movement we expect, will lead to a further structural decline in the average oil price.