The world’s oil markets have crashed in the last two years, and while there is much energy expended on predicting where oil will go next, little investment attention is paid to the underlying causes of those changes. Tom Nelson, Head of Commodities & Resources, looks at the changing political and economic dynamics that are driving the global supply of oil and the shifting demand patterns that will shape the future of the oil markets.
The changing dynamics of global oil markets
The changing dynamics of global oil marketsTom Nelson, Head of Commodities & Resources, Investec Asset Management
“One hundred dollars is a fair price for everybody – consumers, producers, oil companies. It’s a fair price. It’s a good price.” Ali al-Naimi, Saudi Oil Minister, 12 May 2014
“It is not in the interest of OPEC producers to cut their production, whatever the price is… whether it goes down to $20, $30, $40, $60 it is irrelevant.” Ali al-Naimi, Saudi Oil Minister, 22 December 2014
In 2014 the oil market changed forever. As can be seen from the contrasting statements made by Saudi Arabia’s vastly experienced then oil minister between May and December of 2014, the Kingdom abandoned its role as oil market moderator in the second half of the year. Enough has been written about the theoretical motivation behind this policy reversal, but two points need to be made clear. First, this move marked the end of a long and largely successful era for Saudi Arabia as the de facto swing producer of the Organization of Petroleum Exporting Countries (OPEC). Second, the decision was taken in the knowledge that oil prices would fall significantly – Saudi Arabian officials expected US$60 to US$80 per barrel as the likely equilibrium pricing level, based on US shale economics and lack of global spare production capacity. But within 14 months of a chaotic OPEC meeting in November 2014, when Saudi blocked calls from poorer members for production cuts to arrest a slide in global prices, Brent oil was trading at US$27 per barrel, 77% below its June 2014 peak.
Given the change in the oil market structure following the Saudi policy reversal, we should not be surprised to find it in a state of considerable uncertainty. Without a moderating influence, and with huge movements in supply, demand and inventory levels over the last two years or so, analysts are struggling to forecast when the market will return to balance. More specifically, the increased efficiency and productivity of US shale, combined with sharply falling service and drilling costs, has improved the economics of this important new source of supply. Little wonder then, that the investment community has a diminished level of confidence in its ability to forecast short-term oil prices. After all, analysts largely failed to spot the crash, since which time the market has become significantly more volatile and increasingly opaque. This is not helped by less-than-perfect data, with material differences in both historic and forward-looking numbers from some of the leading agencies and providers.
Rather than attempting to forecast when excess storage levels will be eroded or at what oil price US shale activity will pick up, perhaps it is more relevant to concentrate on the changing structural dynamics of supply and demand for oil. These factors should shed some light on why Saudi Arabia changed course, but might also help us to understand the evolution of the oil market. While much of the recent commentary has been around supply, marginal costs and market share, the demand side of the equation cannot be ignored.
Supply and demand tensions
The outlook for global oil demand is best defined by a tension between growing population, consumption and transportation on the one hand, and energy efficiency, electric vehicles and climate change on the other. Oil demand continues to grow at over 1% per year, led by gasoline demand and the developing world (India accelerates while China slows), but it seems logical that over the next 20 years there will be a transition away from the internal combustion engine (ICE). The speed of that transition is difficult to predict. While it is tempting to bet on the unstoppable force of human ingenuity and scientific progress (specifically in electricity storage), we do not underestimate the immovable object of humanity’s love affair with the ICE. It is telling that the debate has shifted from peak supply (peak oil) to peak demand in less than a decade, but we would not be surprised to see oil demand continuing to grow until 2025-2030, with transport demand the hardest to displace.
Of course, it is rational to assume that the Saudi decision to increase production in a weak market in 2014 and 2015 took account of a long-term view of oil demand. The prospect of giant Middle Eastern oilfields as stranded assets when the world’s transport system is electrified, and the resulting effect on those economies, is clearly an important factor not just in the 2014 decision but in Mohammed bin Salman’s subsequent ‘Vision 2030’ reform package. As with all natural resource endowments, Saudi’s oil wealth is more precarious than it might seem. It is also noteworthy that just as Saudi Arabia seeks to increase its share of the global oil market by not rationing its production-to-support prices, it is also looking to monetise the Saudi Arabian Oil Company, known as Saudi Aramco, via an initial public offering of around 5% of the stock.
The structural changes on the supply side are more tangible. US shale oil production added approximately 4 million barrels per day, or 5%, to global oil supply between 2011 and 2015, which Saudi Arabia was prepared to accommodate until its market-share policy change in 2014. The effect of the additional US shale production was counterbalanced until mid-2014, by the collapse of Libyan production amid intensifying civil strife as well as international sanctions on Iran which reduced its production. But the acceleration of US shale in 2014 was clearly a major contributing factor to the price tumble, as was the improvement in US-Iranian relations, particularly as demand growth in 2014 was below trend.
The market is currently fixated on the economics of US shale. Having grown at 1 million barrels per day for four years, this industry has now contracted by almost a million barrels per day. This is not altogether surprising, given that 80% of oil rigs in the US now sit idle and over 60 US shale companies have filed for bankruptcy. But as oil prices move higher, US shale activity will resume – with a broad range of expectations around how much, and at what oil price.
Outside the US, the oil industry is creaking. A decade of poor cost control, followed by a price crash, has left many oil-producing countries and companies in very weak financial condition. Investment in new projects has fallen sharply, and studies suggest that this could lead to a meaningful supply shortage by the end of this decade. In addition, the exploration track record of the industry has been very poor in recent years, and there is not much spare production capacity on the side-line. If demand continues to grow, we may indeed require higher prices to incentivise the development of once-shelved projects.
Technology will clearly play a large part on both the supply and the demand side. The ability to recover hydrocarbons from rock has enabled the rejuvenation of the US oil industry through shale production. In time, battery technology will enable the transition of global transport systems away from hydrocarbons. Were it not for these technological advances it seems inevitable that oil prices would have moved much higher. If technological progress accelerates, the recovery of oil from existing fields will increase, keeping supply high and prices low. Batteries are becoming increasingly advanced, enabling a quicker and more widespread move to electric vehicles, further placing a ceiling on oil prices. However, if technological progress stalls, then we will need more oil for longer and prices will rise.
We can say with reasonable confidence that without Saudi Arabia as a market moderator, the oil price will probably be more volatile than it was before 2014. While it has become fashionable to lament the end of the oil era, we tend to the view that oil and gas will have a somewhat larger and more extended role to play in the transition to a lower carbon future than is generally accepted in the market. This will present interesting investment opportunities for the reduced number of active market participants in the sector.