Oil is now clearly a cyclical commodity that is in a period of over-supply. According to recent commentaries from the International Energy Agency, the excess of production over consumption was as much as 3m barrels a day in the second quarter of this year, which is why prices have fallen. The question for producers, consumers and investors is: how long will it be before the cycle turns back up?
The initial caveat, of course, is that the “normal” oil market could be overturned by political decisions at any time. The Saudis, instead of greedily trying to maximise their market share and imposing huge losses on others, could decide that the stability of the region, and of their own kingdom, would be better served by cutting production and settling for a new equilibrium. There is a chance of that, as I wrote a couple of weeks ago, and the Saudis are under huge pressure from other Opec members but there is a mood of rigid arrogance in Riyadh which suggests that the necessary climb down will not come easily. What follows assumes that King Salman bin Abdulaziz al-Saud and his son the deputy crown prince stick to their current policy.
What then drives the cycle ?
On the supply side, the prospect is of increased production for at least the next two years. Iran will slowly increase its output and exports over the next 12 months, as explained in an excellent briefing paper from CSIS – the US academic think-tank. That will add 400- 600,000 b/d to supply. Beyond that will come resources from new projects and the upgrading and refurbishment of some existing producing fields. BP and some of the US companies may be too timid to go into Iran at the moment but many others will not hold back. As sanctions fall away, Iran has an entirely rational interest in increasing output and exports. A very cautious estimate would be that 1m barrels a day could be added before the end of 2017.
The next question is whether after another week of volatility – prices are settling below $50 with a clear downward trend over six months – low prices will force production cuts in the US or anywhere else. Production of shale (often known as tight oil) is flexible and output can be reduced relatively easily. The issue is whether the costs of fracking are covered at $40 or $45 a barrel. No one is quite sure, and so far the industry has responded to the price fall with impressive cost cutting. But that cannot be unlimited and a prudent guess would be to assume that US unconventional oil supply has peaked and will fall by perhaps 20 per cent over the next two years. Elsewhere, some production will be halted in the North Sea and other provinces where costs are high but in general operating costs are below $40, which means that output will be maintained.
What about the demand side of the equation? The International Energy Agency’s prediction in its latest note was that faster economic growth would start to reduce the excess supply in the second half of this year and through 2016. But its forecast was written before the Chinese downturn became obvious and now looks outdated. For most of the last decade China has been the engine of economic growth not just in Asia but also for major western countries such as Germany. In the oil market, China has been and was predicted to remain the main source of demand growth, with consumption in the US, Europe and Japan flat or declining. The Chinese economy has slowed, as long predicted by sharp observers such as Michael Pettis. The impact of the downturn on spending and investment will take time to work through. Instead of the anticipated demand increase of about 350,000 bd this year and next which the IEA had suggested, it seems prudent to assume that Chinese oil demand will be flat this year and will increase only modestly in 2016 and 2017.
You can vary the calculation using your own assumptions on each of these points but the inescapable conclusion is that, short of a political change of heart in Riyadh, the surplus of supply over demand will persist for at least the next two years or longer. Even when supply and demand are back in balance the market will have to cope with the volume of stocks that are being built up.
Therefore, the cycle will only turn when the postponement of new projects begins to have an impact on total supply. Many new projects have been postponed already, and many more will suffer the same fate over the next few months. The impact, however, will be gradual. Existing producing fields, once they are past their plateau production levels, decline only slowly. New projects capable of replacing those supplies typically take four to six years to come on stream. In other words it will be about five years before the cancellation of a project today will impact on the physical supply-and-demand balance.
It is impossible to be precise but on these fundamentals the cycle will take at least five years to turn and quite possibly longer. The news, good or bad depending on where you are sitting, is that low prices look set to stay.
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