- OPEC confirmed to maintain its strategy in place, pushing oil prices lower
- Volatility will remain high with the US dollar and speculation as the major downside risks
- Oil price recovery expected in 2016 as a result of a better balance between supply and demand
Oil price moving sideways while awaiting trigger
In recent weeks, oil prices remained under pressure and even dropped to the lowest level since February 2009. The situation of oversupply is already in place for quite some time, pushing prices lower by 65% in the past 18 months (Figure 1). The last part of the decline was triggered by Organisation of Petroleum Exporting Countries (OPEC) which confirmed its strategy by not cutting its oil production ceiling – as hoped by many – but to raise its production ceiling instead. The new production target was set at 31.5 million barrels a day (mb/d) from 30 mb/d. This new official level is much closer to the actual production numbers than the old official production ceiling.
Although the net global oil supply was not raised, the OPEC decision to stick to its strategy was received as negative news for oil prices. After all, it was clear that the oversupply would not decline in the near term. On top of this, oil production in Non-OPEC countries has been less affected than expected by lower oil prices so far. Moreover, we think that the moderate rise in global oil demand will not be able to vanish the imbalances between supply and demand in the near term.
Why is OPEC flushing the market with oil?
Oil demand recovered rapidly after the financial crisis. The extra demand for oil was almost fully covered by a rise in Non-OPEC oil production. Until the OPEC meeting of 27 November 2014, OPEC set its production level based on the global demand for oil minus the production of Non-OPEC countries, the so called ‘Call-on-OPEC’. During a similar situation of rising Non-OPEC production in the eighties, OPEC – and Saudi Arabia in particular – cut its output levels. At that time, this strategy did not work because its market share was cut back to an absolute minimum level.
To prevent a similar situation, OPEC decided to postpone its original mission of ‘stabilising oil prices and oil supply in favour of producers, consumers and investors’. As can be seen in Figure 2, this strategy seems to work as the OPEC market share is rising. The Non-OPEC oil supply is falling under pressure, while OPEC is able to keep its production at current levels. It may even increase its output during the coming year if sanctions against Iran are slowly lifted. As International oil companies currently set their budget targets for 2016, it seemed to be a wrong timing for OPEC to adjust its strategy at last weeks’ meeting. The main scenario for OPEC is that global demand will continue to increase at a moderate pace. As a result, the ‘Call-on-OPEC’ will therefore increase which ultimately will result in diminishing of the imbalance between supply and demand.
By raising the official production ceiling of the OPEC towards 31.5 mb/d, actually OPEC aligned its official production ceiling with its actual production (Figure 3). OPEC did not confirm whether this new production ceiling included a higher oil production from Iran in 2016 or not. Possibly OPEC will give some more insights at its next meeting when there is more clarity surrounding the actual status of the Iran sanctions.
Near term volatility to remain high
In the near term, we expect volatility of oil prices to remain high. A test of the 2009 lows (USD 36.20/bbl) cannot be excluded. The market is strongly positioned for further price declines which is proven by the large number of short contracts in the market. However, now the ECB and the OPEC meetings have taken place, only two important events remain for this year. The first one is the final conclusion of the UN climate talks (COP21) in Paris. Although there will most likely be no immediate near term effect for oil in the final statement of the Climate conference in Paris, a firm global deal on cutting carbon emissions could hurt oil demand in the longer-term.
The second event is the US monetary policy decision by the Federal Reserve (Fed) on December 16. About 80% of the market is pricing in a Fed rate hike based on the continuous economic growth. The biggest (indirect) risk for the oil price is the movement of the US dollar. If the Fed actually increases interest rates as we expect, the US dollar could appreciate somewhat further. This could automatically have a negative effect on (US dollar denominated) oil prices. There is a risk that investors will start to close their short positions ahead of the year-end. Especially when all events have passed, investors could take profit on recent downward moves before markets become illiquid during the coming Holidays. This could prove to be somewhat supportive for oil prices.
Recovery expected in the course of 2016
Although there are some downside risks for oil prices in the near term, we believe that oil prices will recover in the course of 2016. In line with the view of both OPEC and the International Energy Agency, we believe that the moderate growth of oil demand will remain, mainly driven by Asian emerging countries like India and China. Furthermore, production of Non-OPEC countries will face more pressure as long as oil prices remain low. Investments in the oil sector are often put on hold. Especially some smaller (mainly US) oil companies will struggle to finance their activities as lower profitability challenges their investment plans. Although Iran might increase production in 2016, as a result of lower sanctions, this extra supply should be balanced out by the rise in global demand and the drop in Non-OPEC production. When the market starts to anticipate a better balance between supply and demand – or in other words less oversupply – oil prices already could start to recover.
We think the number of short positions are excessive. We expect that these short positions will be closed for a significant part. Possibly in this year due to lower liquidity in the market, and in the beginning of 2016, as downside potential of oil prices continues to diminish. This will likely reduce the downside pressure. We expect some further appreciation of the US dollar during H1 2016. However, after that, the upside potential for oil prices is no longer capped by this.
The upside potential of the oil prices should be seen in the right context of ‘lower oil prices for longer’. After oil prices had traded around – and even above USD 100/bbl – for many years. Arecovery of oil prices from current levels towards USD 60/bbl would still mean that both producers and consumers are confronted with low oil prices from a historical perspective. Nevertheless, an oil price of USD 60/bbl would give some space to oil producers, while consumers would still benefit from relatively low prices.