- Threat of expanding oil supply, increasing risk of even lower oil prices
- Impact of low oil prices on oil production and demand will become visible in second half of 2015
- Search for new equilibrium will be accompanied by heightened volatility and large price swings
US to make next move in supply-driven market
Supply factors are dominating the oil market. The current oversupply will not diminish fast. The OPEC countries, and particularly Saudi Arabia, have no intention of drastically reducing production. They know that this would not alter the total oil supply as non-OPEC countries such as the US and Canada would quickly step in to fill the gap. In other words, the OPEC would merely lose market share without achieving its objective of raising oil prices. The OPEC is therefore unlikely to change its policy at its next meeting in June.
To achieve a supply-driven increase in oil prices, US oil production needs to be reduced first. The number of drilling rigs has now been halved, but with zero effect on output. In fact, production has simply continued to grow further (Figure 1). Thanks to the implemented efficiencies in the oil production process and cost reductions due to the low oil price, this has had no effects, or at least no visible effects, so far.
The nuclear deal with Iran
The negotiations between Iran and the west resulted after long negotiations in a framework agreement. In the coming three months, the details regarding lifting sanctions and reducing the nuclear activities in Iran will be worked out. Regarding reducing the sanctions, this will depend very strongly on the support that President Obama can muster in the Republican-dominated Senate. If that support is forthcoming and the sanctions are partially lifted, Iran could restore its oil production, allowing more oil to reach the market. Sanctions will only be lifted after inspections done by the International Atomic Energy Agency. However, if sanctions eventually are lifted, Iran could increase its oil production and oil exports resulting in (even) more oil on the market.
Problem of oversupply may even worsen…
Due to the sanctions, Iran currently exports some 1.25 million barrels per day less than before. The expectation is that Iran could produce/export about 500k barrels of oil extra per day within three months of signing an agreement, potentially adding a further 500-750k barrels per day in the nine months thereafter. OPEC’s total market share will rise as a result of this. Ahead of this expansion of supply, the downward pressure on the oil price will increase sharply due to speculation.
The other factor that could cause even greater oversupply is the evolving situation in Libya. According to official government sources, Libya is poised to reopen its two largest oil ports, Ras Lanuf and Es Sider, now that the rival government has withdrawn from the region. The two ports can jointly process some 600k barrels of oil per day. If the ports are actually opened, Libya can step up its oil exports in the coming months. However, due to the extremely fragile situation, the oil supply from Libya remains very unreliable. This also seems to be the main reason why Saudi Arabia has actually slightly increased its oil production to serve as security for the sharply fluctuating supply from Libya.
Finally, extra oil could reach the market once the physical storage depots are entirely full. The contango (spot prices lower than future prices) in the forward curve (successive series of future oil prices) is leading to a clear build-up of speculative physical positions. In other words, speculators are buying up oil and putting it in storage in the hope of selling it later at a higher price. However, as soon as the storage depots are entirely full, and the extra oil has nowhere to go, the oil price may come under extra pressure. The same applies, incidentally, if the structure of the forward curve changes in the direction of backwardation (spot price higher than forward prices). This could spark a selling wave to offload these speculative oil stocks.
The American dilemma
The OPEC will not reduce oil production. In fact, its output may even increase with the return of Iran. The upshot is that any production reduction must come from the non-OPEC countries, with the US leading the way (Figure 3). This puts the US in a tight spot. On the one hand the deal with Iran is crucial to prevent Iran from developing a nuclear weapon and thus possibly triggering an arms race in the Middle East. Which is the last thing anybody wants in this pivotal region for the world’s energy supply. On the other hand, the deal with Iran could result in:
- The partial lifting of sanctions against Iran. This could lead to a much larger supply of oil to the market, resulting in a lower oil price.
- Intensifying debate with Israel and Saudi Arabia, which both oppose such a deal and are already extremely displeased with the US attitude towards the regimes in Iran and Syria.
- More unrest in the US Senate. The Republicans have already made it clear that they will not support such a deal with Iran, adding that President Obama is in his last term and that a future Republican president could revoke such a deal. This calls the future value of such a provisional deal into question.
- Even greater pressure on the non-OPEC countries, and chiefly the US, to lower their oil production in order to restore the balance between supply and demand and thus support the oil price. This could happen in a coordinated action, together with other major oil producers. The OPEC has clearly put the ball in the court of the emerging oil producers (read: the US) to take this initiative.
But new tensions are creating upward risk
Since the end of March a coalition of Arab countries, led by Saudi Arabia, have been carrying out air strikes on the Houthi rebels in Yemen. The rebel forces have recently gained control over a large area. Earlier this year, they staged a coup and deposed President Hadi. He, however, regards himself as the sole legitimate head of state and can count on the backing of about ten neighbouring countries, including Kuwait, Qatar, the United Arab Emirates and Egypt.
The new geopolitical tensions arising from the rebel attacks in Yemen give rise to a fresh geopolitical risk for the oil production and, hence, the oil price. First of all, Yemen is situated along the vital maritime corridor for the exportation of oil from the Middle East through the Suez Canal to Europe. In addition, this unrest is exacerbating the risk of a proxy war, as the Shiite Houthis are backed by Iran, the arch rival of Saudi Arabia. The upward risk for oil prices therefore does not stem from the possible threat to Yemen’s oil production, which is only of marginal importance. The real problem is that two of the most important OPEC oil producers are diametrically opposed to each other. The resulting heightened risk of an escalation is making the market nervous. However, we do not consider escalation very likely, so that the oil production of both Saudi Arabia and Iran will probably remain unaffected.
What was the reason again for the lower oil prices?
Over the past years the oil price remained within a stable but broad bandwidth of USD 80-120/barrel. During the oil price free fall in the last quarter of 2014, oil prices broke through the lower level of this bandwidth, with Brent oil even plummeting to a low around USD 45/barrel. This sharp decline was mainly attributable to a combination of circumstances: oil oversupply, the stronger dollar and disappointing demand for oil.
What followed was a rapid recovery towards USD 60/barrel, mainly driven by expectations and assumptions. The expectation was that the low oil price would give the economy an extra impulse and thus spur demand for oil. And the assumption was that the low oil price would dampen oil production as expensive oil projects would no longer be profitable. However, the effects on both the supply and demand of oil have not materialised so far. We believe that these effects will occur, but later than expected. As a consequence, the Brent oil price remained stuck at around USD 60/barrel. And the recovery of WTI was even much weaker because the sustained increase in US oil production combined with very high stocks kept the price under pressure.
Downward risks remain present, because not much has changed in structural terms. The uplift in demand is very moderate and the supply of oil is abundant. This is creating downward pressure. Moreover, the steadily strengthening US dollar is not helping matters either. A stronger dollar is usually negative for commodity prices (which are traded in dollars), and this also goes for oil. Price-increasing effects are currently mainly determined by geopolitical tensions.
Oil price recovery not until second half of the year
The chance of prices falling further has risen because of the possibility of extra oil being brought to market. For this reason, we do not rule out oil prices coming under renewed pressure in the next two or three months and testing the lows reached in January (Brent USD 45/barrel, WTI USD 42/barrel).
The growing demand for oil as a result of economic growth will only become visible in the course of the second half of the year. The negative consequences for oil production are also only expected to become visible in the second half of the year, when the consequences of the low investments will start feeding through to the total (non-OPEC) production levels. This is why we expect oil prices to pick up later in the year. Our year-end forecast is USD 65/barrel for Brent oil and USD 60/barrel for WTI.
Due to the lower prices in the first half of the year and the expected recovery later this year, we expect the average oil prices for 2015 to work out at USD 60/barrel for Brent and USD 55/barrel for WTI (see Table 1).
All in all, we are convinced that the era of oil prices between USD 80-120/barrel is over. A USD 40-80/barrel bandwidth is more probable in the current period (Figure 5). This new bandwidth may well remain intact for several years, before the price breaks through the upper limit. In our view, the ideal oil price at present would be somewhere around USD 80/barrel. This is a level at which both consumers and producers appear to feel comfortable. The search for an equilibrium around USD 80/barrel may, however, well be a prolonged process with great volatility.