By John Richardson
THE first misunderstanding about oil prices, which everyone now accepts was wrong, arose because people took too much notice of existing cost-per-barrel economics and so assumed that from October of last year, the US would close down huge amounts of shale-oil capacity.
This didn’t happen because a.) Costs were lower than anticipated because of improvements in shale technologies and b.) Because of human nature.
The next theory to gain credence late last year, which was very rapidly dismissed, was that Saudi Arabia would cut production in order to drive prices back up to $100 a barrel.
Then we had a third misplaced type of thinking: That the early February to end-June 2015 recovery in pricing was about real supply and demand fundamentals. What it was instead about was financial players anticipating a tightening in physical supplies that still hasn’t happened.
A fourth current idea, which I think is also wrong, is this: Saudi Arabia simply has to cut back production fairly soon in order to balance its budget.
But as The Economist first pointed out last year, and repeated again last week, Saudi Arabia has lots of financial leeway to keep on pumping crude at high volumes for a lot longer yet. In its latest edition, The Economist wrote the following about Saudi Arabia and other Gulf States:
Saudi Arabia, along with the far-richer-per-head satellites of Kuwait, the UAE and Qatar, can keep this up for some time.
With the world’s lowest debt-to-GDP ratio last year (an enviable 1.6%), it has enormous room to borrow. It also has room to save. Simple measures such as imposing sales and property taxes, or raising absurdly low local energy prices, could quickly help fund budget shortfalls.
The question then is obviously “Will Saudi Arabia and the rest of the rich Gulf states maintain today’s very high levels of production?
I think the answer is a definitive yes because Saudi Arabia and these other rich Gulf states want to make sure that they are not forced to leave oil, their most valuable asset, permanently in the ground because of losing market share to other energy sources – including renewables.
The Economist article I’ve already linked to above is also helpful on this point:
Based on experience from the 1970s and 1980s, oil producers learned then that when the cartel pushed prices too high, consumers rushed to find other sources of energy. As a result, it took OPEC nearly 20 years to regain the market share it eventually lost.
And a fascinating interview in last week’s Petroleum Intelligence Weekly, Rex Tillerson, chairman and CEO of ExxonMobil, made these other points about Saudi policy:
- A few years ago, when prices soared to in the region of $140 a barrel, they invested billions of dollars in developing spare capacity of 2 million barrels a day.
- Now they are wondering whether this was all a big mistake because of the fall in prices.
- So they are just waiting for the market to reach the point where it becomes crystal clear that this question posed by Tillerson is answered: Where are the marginal barrels and how elastic are they?
This leads us on to a fifth theory on oil, which I don’t think anybody now still thinks holds true. This was the notion that these marginal barrels of production would disappear when prices fell to around $60 a barrel.
Tillerson never subscribed to this theory because as he said in the same interview:
A lot of people thought it gets to $60 and everything would become obvious. I never held that view. I commented early on that I thought people would be pretty surprised at just how resilient this thing is, which is what I told the OPEC meeting when I spoke to them in June.
And, returning to how long Saudi Arabia and other countries will have to stick their current strategy, here is Tillerson again:
I said [when he spoke to OPEC in June] you need to be ready for this to take a while. I think the fact that we have gone through several of these price convulsions this year, shouldn’t be a surprise to anyone.”
And there is potentially a sixth misunderstanding gaining currency at the moment, which is this: “OK, we were wrong about $60 a barrel, but we think $45 a barrel is actually now the breakeven price for all these marginal barrels.”
Not necessarily in the case of shale oil because as Tillerson points out in the same interview, unit costs of shale production will continue to fall – although he stresses that some fields are more efficient than others.
So where does this leave us in forecasting oil prices over the next few years?
First of all, let’s summarise what we do know, which is this:
- Saudi Arabia, and quite possibly the other rich Gulf states, are in this for the long haul – and will only reverse policy when they are certain they have regained market share.
- We also know that nobody still knows what the final breakeven running costs of US shale oil will end up being. What we are equally unsure of it what are the minimum breakeven contributions to paying back capital. This still depends on a.) The willingness of the financial sector to keep supplying the shale-oil sector with cheap money and b.) The extent of restructuring in the sector. Debts could be written off, thus reducing capital payments.
- On the demand side of the equation, events in China tell us that global demand growth for oil can only weaken over the next few years.
What we don’t know is how Western central banks will react from hereon in to global economic weakness. This is absolutely vital to both understand and constantly monitor as the banks are responsible for today’s vast oversupply in crude and so Saudi Arabia’s efforts to regain market share.
So here is a repeat of three extreme scenarios for the next few years, with many other potential pricing points in between:
- No more major Western central bank stimulus and you are looking at prices returning to their long term average of around $30 a barrel.
- More major Fed etc. stimulus and we could be back to $100 a barrel.
- Or around $50 a barrel in a world of perhaps some stimulus, but still weak underlying demand.