Crude oil prices have plunged by $25, or more than 20 per cent, since mid-June, raising many questions. How low might prices go? If they rebound, at what level will they stabilise? Will Saudi Arabia and Opec move to cut output when they meet next month? At what price level might US shale oil production be affected and how severely?
One thing is certain: even the current lower prices are rapidly creating winners and losers. Losers are producers, countries and governments. If Brent falls to $80, Opec countries would lose some $200bn of their recent $1tn in earnings, affecting not only their ability to earn enough to cover the post-Arab Spring expanded budgets, but also their capacity to service debt without triggering defaults. And for the US, if prices fall much further, capital expenditures to expand production would have to be cut, potentially slowing the US shale revolution.
On the other hand, the world economy as a whole would enjoy the equivalent of a huge quantitative easing programme, helping to spur stalling economic growth. The decline in prices would generate a $1.8bn daily windfall, about $660bn annualised. Tracking this into gasoline prices, in the US, where last year some $2,900 per household was spent on gasoline, the windfall would amount to a tax rebate of just under $600 per household. It would affect all consumers globally save for those in Opec countries, who already pay little for fuel.
Prices have plummeted for several reasons: some of the decline is attributable to market sentiment, some to market fundamentals and, to a large measure, the geopolitical landscape. Brent crude has averaged around $110 per barrel since the Libyan disruption took 1m barrels per day off markets. Despite a Saudi production increase in 2011, $110 Brent was about $25 a barrel above traded prices just before the Libyan disruption. The main reason why Saudi Arabia could not damp prices was that the disrupted supply was light sweet crude, and refiners who needed it could not replace it with heavier, higher sulphur-content crude.
Meanwhile, two different trends have unfolded since 2011. The first has been the rise of domestic governance problems across oil exporters. Before February 2011, only some 400,000 b/d of oil was off-market because of disruption. Since then, disrupted supply has grown to more than 3.5m b/d at times, counting sanctioned Iranian oil and crude from Nigeria, Sudan, Syria and Yemen, to name a few, leading to geopolitical jitters.
The second trend is the tremendous growth of US oil output. Production is getting less costly every year and break-even costs are plummeting to much lower levels than commonly believed, certainly lower than $75 per barrel.
One of the dilemmas for Opec stems from the division of interests of the sour, medium and heavy oil producers of the Gulf and the light crude producers in west and north Africa. The US supply surge is light and sweet and has created a glut of this kind of oil globally. No matter how much crude oil Saudi or the rest of Opec cuts, it will not correct the oversupply of light crude in the market.
Yet other fundamentals are also at work. The global economy is weak and oil demand is rising at the puny rate of less than 1m b/d. Any projected increase in economic activity and demand for 2015 will probably leave an overall surplus of 1m b/d, which would weigh even more heavily on prices unless Opec cuts production. Political risk also appears more bearish than bullish, at least for the near term. An Iranian nuclear deal would mean more oil on the market, as would a continued surge in Libyan production.
Finally, price weakness has resulted in a host of conspiracy theories, based on Saudi Arabia having lowered the price of its oil for customers in Asia – price cuts now matched by Iran, Iraq and other Middle East producers. Statements by Saudi leaders indicate that they think US production growth would be hampered with oil prices much below $90, and it is already clear that with Brent at $90, a widening spread between Brent and WTI, the US benchmark, in 2015 could bring WTI below $75 a barrel. Additionally, lower prices would cost Iran and Russia dearly. Both countries are spending money in the Middle East in ways the kingdom does not like.
Are these rumours valid? Only time, and perhaps the Opec meeting in November, will tell. If prices continue to fall, US producers could prove to be a more resilient bunch than is commonly thought.
Ed Morse is global head of commodities research at Citi