From 2011 to mid-2014 oil prices had been fairly stable, moving in a range between $100 and $125 a barrel. Since then oil has tumbled more than 50%, dipping under $50 a barrel for the first time in 5 ½ years. The continued descent leaves many wondering: where is the bottom?
Supply > Demand
The latest OPEC Monthly Oil Report reports that global oil supply continues to outstrip demand. The report makes it hard to compare apples to apples but we can nonetheless get a sense of the imbalance. World oil demand averaged 91.15 million barrels a day (mb/d) in 2014 and 92.69 mb/d in the 4th quarter of 2014; but while demand actually grew from year ago levels, global oil supply averaged 93.16 mb/d in December 2014. That’s quite a difference!
Source: OPEC Monthly Oil Report, January 2015
You can see from the chart above that there actually has been a slight pullback in global supply from its peak in October of last year. Yet prices continue to remain depressed. What’s going on?
For one, the U.S. continues to grow output, having increasing production in each and every quarter of 2014, but rising prices are expected to eventually curtail supply from the United States. With oil at $45, many oil rigs become unprofitable to operate. Output from North Dakota has already fallen, albeit due to reasons related to regulation rather than from producers acting to protect themselves from falling prices.
Additionally OPEC estimates that global oil demand will be flat to slightly higher in 2015, due to a sluggish global economy, suggesting that relief in the form of increased demand will not be coming any time soon. Producers will have to cut supply to affect prices.
So, that sounds pretty simple right? Producers cut back on supply, pocket their cash and go home to smoke cigars and drink martinis.
Except it’s not that simple…
Cut and run, or stay the course?
Any producer who cuts back at this point risks losing market share, which means less money in their pocket in the future. If Saudi Arabia were to cut supply and demand suddenly recovered, the U.S. or another nation might be well placed to swoop in on their now-exposed turf.
Which is why OPEC members are reluctant, even agreeing in November to maintain their collective output target of 30 million barrels a day for the first half of 2015.
It’s an example of the classic Prisoner’s Dilemma game. In game theory, Prisoner’s Dilemma shows us why two or more actors might not cooperate even though it might be in their self-interest to. By cooperating to cut oil supply, all members of OPEC can benefit, but it takes just one sneaky OPEC member to renege on the agreement to turn it all on its head.
Don’t expect Saudi Arabia to take the bullet of cutting supply either, they’ve been burned before. In the 1980s there was a similar oil glut and the Saudis tried to defend prices by cutting production by nearly three-quarters, going from 10 mb/d to less than 2.5 mb/d. The other OPEC members didn’t seem to get the memo however and prices remained low, leading to massive Saudi debt.
So now the strategy is to defend market share, letting producers that have the highest costs shut down as they lose profitability. The Arabian Kingdom is not actively pushing prices down, in fact they have kept production flat to slightly lower, but they are letting the market find a bottom and are willing to tolerate the hit to their bank accounts.
So what happens now?
Winners and Losers
Saudi Arabia can handle lower oil prices for a while. When prices were high the Kingdom saved – amassing nearly $900 billion in reserves.
Other countries will be hit harder. Among the biggest losers: Venezuela, Iran and Russia.
Venezuela will be particularly hard-hit. Foreign reserves are at their lowest in over a decade and every dollar drop in the price of oil results in a loss of about $500 million dollars off export earnings. Deutsche Bank calculates Venezuela’s break-even price for oil, the price that it needs to earn per barrel to balance the national budget, to be around $120.
On the surface Russia looks safe. Its break-even price places it in the middle of the pack alongside Saudi Arabia and with reserves of $420 billion the ex-Soviet nation should be fine, except its currency is in the toilet.
When the oil price slide started the currency stood at about 35 roubles per U.S. dollar. Nowadays 1 U.S. dollar buys 65 roubles. The longer the currency stays devalued, the harder it becomes for the Russians to weather the storm.
The media is making the battle appear to be between the two biggest oil producers in the world: Saudi Arabia and the U.S.
The standard narrative is that surging U.S. oil production represents the greatest threat to Saudi market share and the Saudis are fighting back by letting the maxim of survival of the fittest run its course.
So far it doesn’t seem to be working.
A report from energy consultant Wood Mackenzie analyzed production data from over 2000 oil fields around the world to see how many could potentially go under due to low oil prices.
The answer: not many.
That’s a sobering statistic.
At $45 a barrel, which is where we’re at, only 400,000 barrels a day are unprofitable. That represents just 0.4% of global supply, and half of that comes from onshore U.S oil.
Many operators will also continue to operate even at a loss – preferring to increase inventory rather than shut down projects completely.
So far the idea that U.S. shale will be forced out of production is not borne out in the numbers. In the chart above you can see the production numbers for the 4 largest shale sites, all of which have increased. In fact, none of the seven regions analyzed by the EIA – accounting for 95% of domestic oil production growth – have decreased production.
What does the future look like?
It may be that low prices are here to stay – at least in the near-to-short term. Global growth, and therefore oil demand is expected to be weak. No one wants to cut supply, which acts to keep prices low. It is highly possible that we are entering a period of low prices that oil producers will just have to deal with, piling up their inventories until demand picks up.
We will see oil companies hold off on expensive investment into new projects. No one will want to spend the extra money. The hardest hit producers in the short-term are likely to be countries where nationalized oil provides the revenues used to finance large swathes of government spending.
In the long-term, expect to see prices pick up as demand rebounds. When that happens is beyond the scope of this article but it is unlikely that this episode represents some longer-term trend where oil is beginning to lose dominance to alternative energies – many of which are not viable enough to be robust substitutes.
Watch the skies – or rather, the oil fields.