Further oil price recovery on hold
On 6 May 2015 oil prices reached their highest point since the onset of the recovery in January after the massive price fall last year (Brent – USD 69.63/barrel and WTI – USD 62.58/barrel). Oil prices have now again come under downward pressure (Figure 1). The recent stagnation and increased pressure on the oil price is attributable to several factors. Before addressing these, we would emphasise that the fundamentals have changed little since January. There was, and still is, an oversupply situation and this will remain the case in the near future.
Now for the reasons underlying the recent price pressure. The first factor driving the oil price recovery was the weakening of the US dollar. Recently, the dollar has strengthened again due to Federal Reserve policy expectations combined with increased concerns about Greece.
A second contributory factor was the building up of speculative long positions, notably by hedge funds. Meanwhile, hedge funds are winding down their speculative positions. The reduced number of long positions has brought the oil price under renewed pressure.
A final factor for the revived pressure on the oil price is the fact that the increase in production efficiency gains coupled with the higher oil price has made many shale oil operations in the United States profitable again. Whilst output continues to edge lower, oil production in the US is projected to remain around its current record level (Figure 2), the reason being that oil companies have already been able to sell their future oil production at higher prices on the futures market. As a result, it remains profitable for them to continue or resume production. Already drilled but still non-producing oil wells can now also come on stream. This is confirmed by the fact that, after a period of nearly six months, the drop in the number of drilling rigs is appearing to slow and may therefore stabilise.
OPEC decision looks like formality
OPEC will decide on its production quota on 5 June. Whereas the initial market consensus was that OPEC would cut its quota after all in June, now the market – like ourselves – is counting on OPEC to leave its policy unchanged. This would mean OPEC maintaining its production quota of 30 million barrels per day in an attempt to preserve its market share. Even the spokesmen for Iran now say that OPEC will very probably leave its production unchanged. Prior to the meeting in November 2014, Iran, together with Venezuela, was actually lobbying for a production cut in order to prop up prices.
OPEC’s strategy report forecasts rising oil production from non-OPEC countries until at least 2017. By keeping up production in a bid to secure market share, OPEC will not assume the role of swing producer. Besides various signals from spokesmen for OPEC members, this is also evident from the fact that, unlike in the US, the number of driiling rigs in the Middle East is rising.
Interestingly, OPEC may even want to go a step further than maintain the quota/output and actually increase its quota/production. OPEC currently already produces well above the quota it has set itself. But oil tanker bookings show that Iraq foresees higher production in the short term. Meanwhile, Saudi Arabia is producing at a record level and Libya might be able to step up its production in the short term, provided there are no disruptive internal strikes or other forms of unrest. Venezuela also recognises that a production cut (and hence higher oil prices) is not on the cards; it wants to increase its production to compensate for loss of income. Finally, Iran could also raise its production and exports as soon as the western sanctions are relaxed. All in all, OPEC seems ready for the second round in the battle with non-OPEC countries for the preservation – or even expansion – of market share. Clearly, this sustained wave of oil into the market will keep oil prices under pressure, leading to lower oil prices for the consumer.
Chinese demand for oil is cooling
The demand side is also expected to exert little upward price pressure because demand is largely driven by emerging markets in Asia, i.e. China. Demand for oil from China is forecast to grow less quickly over the coming years. In the first place, this is a direct consequence of the gradual economic cooling in China. In 2010 economic growth was still running at more than 10%, but the government is now aiming for 7% for 2015. In addition, the transformation from industrial-driven to consumer-driven expansion will change the composition of the demand for energy.
Moreover, evolving regulations on energy consumption and generation are slowly but surely starting to affect the energy mix. A greater focus on renewables, efficiency gains and carbon emission reductions is causing shifts in the demand for coal, gas and oil. The first consequences of this are already visible. According to Petroleum Economist, demand for oil from China increased annually by an average of 500,000 barrels per day between 2003 and 2012, but this growth rate fell back to 270,000 barrels per day in 2014. The link between economic growth and growing demand for oil thus appears to have been abandoned. Recently, Chinese demand for oil rose slightly as a result of the low oil price. This extra oil was used to replenish China’s strategic reserves. As a result, the revival in the demand for oil is expected to be temporary as strategic stocks now appear to be reasonably well-filled.
Downward price risks
In view of factors described above, we expect the current oil oversupply to keep oil prices under pressure for some time to come. In addition, we see the dollar becoming considerably stronger in the second half of the year. This is mainly based on differences between economic growth in the US and Europe, and the related interest rate policy. We expect the EUR/USD exchange rate to sink below par in the course of the third quarter. As a result of the oversupply of oil and the stronger dollar, we do not rule out a sharp fall in oil prices in the short term.
Nevertheless, we are confident that the oil market will ultimately manage to find equilibrium between supply and demand at a higher price level. A balance will need to be struck at a price level that does justice to the new situation of greater supply and a moderately rising demand for oil. In our opinion, the price level at which both producers and consumers feel comfortable is around USD 80/barrel. In the coming two to three years, the oil price will therefore gravitate towards that level. Our expectation for the oil price is shown in Table 1.
The search for equilibrium will go hand in hand with strong volatility and is subject to great uncertainties, such as escalating geopolitical conflicts. Over the next two to three years, economic growth will boost demand for oil. This impulse will largely come from Asia. In addition, oil producers will ultimately have to bring their supply in line with demand. If they do not do so by deliberately reducing production, a price war will ultimately dampen production growth.