The Petroleum Puzzle

With oil prices down 50% from last June and holding steady consumers are looking forward to cheaper gasoline and lower heating bills and investors are rethinking where to put their money; it is a good time to take stock of what might happen next.

As discussed on this blog in late November, both lower demand and larger supply deserve credit (or blame) for the price drop. Weaker economies in Europe and Japan and lower economic growth in China are all reducing global oil demand.  Supply is being boosted by increased production in the US and from unanticipated production in Libya and Iraq.  However, falling oil prices may set in motion forces that could reverse all this as cheaper oil leads to stronger economies and forces some marginal producers out of business. Based on some recent reports, following is a look at how things stand now.

  1. Because oil demand is inelastic, small changes in consumption generate large changes in price. Estimates from the International Energy Agency  cited by the IMF show that oil demand forecasts are down about one percent since last Spring.  That short fall represents about one million barrels per day (mmb/d) given that global consumption is currently 90 to 92 mmb/d.  This probably accounts for about $12 to $15 of the roughly $55 dollar drop in prices.
  2. Figures from the US Energy Information Agency  show world production up about 2 million b/d from 2013 to 2014. OPEC production was down slightly so US, Libya, Iraq and others more than made up the difference.
  3. Saudi Arabia, and OPEC, decided not to cut production in an effort to raise prices. The days when OPEC could cut production and raise prices almost at will are gone, at least for now. The strategy has changed from raising prices to holding market share. Were Saudi Arabia to cut production enough to raise prices, the benefit of higher prices would be enjoyed by other producers – not Saudi Arabia. Far better to keep producers united and wait for today’s low prices to force high cost producers (US shale) out of the market.
  4. The IMF cites a global supply curve for oil published by Rystad Energy Research. If one assumes world consumption of about 90-92 mmb/d, the market equilibrium price would be around $70-$75/barrel.  At $70-$75, some US production would probably be lost and employment and investment in oil exploration might decline slightly.
  5. This figure isn’t far off the futures price for Brent crude looking out a year to 18 months. The chart shows futures prices for Brent, the global benchmark for petroleum, monthly over the next year and then at 18, 24, 36 and 48 months into the future.

Does this mean we can expect $75 oil for a while? Probably not.  The forces put in motion by the drop from $110 to $55 are still shifting and shaping oil production and world demand. Today’s cheaper oil may sow the seeds of future price rises. The most one can say is that oil prices will rebound somewhat, sometime – by how much and when can’t be determined for sure.

The posts on this blog are opinions, not advice. Please read our disclaimers.

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