The right time window to view oil prices
When almost exactly a year ago I made a prediction that 2016 would be the last year of cheap oil, my post stirred controversy − with the spectacular slide of Brent crude price in January from USD 36 to USD 26 per barrel only stoking it up. Today I can confirm that oil has indeed been cheap this year. The average annual price per barrel of Brent has been just under USD 44, representing a USD 9 (17-percent) drop on 2015 and a 12-year low. I also stand by my prediction that oil prices are set to rise in the years ahead.
It is no longer controversial though, as the vast majority of economists dealing with the oil market project a scenario of a moderate price recovery, stimulated by OPEC interventions and tempered by growing US production. This projection is also reflected in the recently unveiled PKN ORLEN strategy, in which we assume 2017−2018 oil prices to average approximately USD 55 per barrel. One might ask what we have based this assumption on and how it relates to the expected price recovery now that oil prices have already moved close to the USD 55 mark.
But before I answer these questions − which are of key relevance to this post − let me first explain what ‘prices’ I am referring to, since not everyone understands the difference between a spot oil price of USD 55 per barrel and an average oil price of USD 55 per barrel forecast for 2017−2018. Oil prices are in constant flux, and can be viewed through various time windows, depending on what we view them for. The window to follow the smallest recognised price movements, called ticks, is of interest primarily to those playing the market. Consumers and producers in the real economy, on the other hand, are interested in broader time windows: daily (daily average prices), monthly (monthly average prices), quarterly, yearly, and long-term. Daily is a typical price window for oil buy and sell transactions. It also serves consumers to monitor prices at the pump.
A closer look at daily prices of crude oil easily reveals that they are influenced by streams of current economic and political information. Every such piece of information is instantly analysed for potential near- and longer-term impacts on supply and demand in the oil market. If it leads market players to conclude that the conditions are about to change, a series of transactions take place to adjust existing positions (future delivery contracts to buy or sell oil). The overall outcome of those transactions drives price movements on the spot market. The problem is we cannot exactly predict the future. While some developments are easy to foresee − although events will often take a surprising turn − others are just the opposite. And if we cannot accurately predict future developments driving oil prices, can we predict how the prices will move in the near- and longer-term?
As a matter of fact, we can. But only on the condition that we switch to a much broader time window and that we treat the numbers denoting oil prices as qualitative measures. If you want to see an elephant, do not use a magnifying glass. Information on the direction of price movements, conveyed by monthly, quarterly and yearly average prices, is much more reliable than information on their size. Also, the bigger the window the stronger the relationship between prices and the more predictable fundamentals, and the weaker the impact of the entirely unpredictable streams of single pieces of economic and political news.
The narrowest reasonable time window to track the correlation of oil prices with the global economy is a quarter, as GDP is estimated on a quarterly basis. What can we see through a quarterly window just now?
• Oil prices are likely to slowly climb from quarter to quarter, from around USD 49 per barrel in the fourth quarter of 2016 to around USD 60 in the fourth quarter of 2018. The average quarterly oil price should go up more than USD 10 (22 percent) over the next eight quarters
• But the rise will not be steady. On November 30th 2016, an OPEC deal was struck, effective from January 1st 2017, which will have the effect of OPEC members cutting oil production in the first and second quarters of 2017 (by a planned 1.2 million barrels a day, although in reality probably less) and lowering the risk of oil price drops in the coming two or three quarters. Non-OPEC countries, including Russia, Mexico and Kazakhstan, are also to join the deal. Its ramifications have already been reflected in oil prices, but the size of the production cut expected by the market is smaller than OPEC’s plan. Higher prices will prompt US producers to ramp up output, and this additional supply will be placed on the market in two or three quarters, slightly pushing prices down. Producers who break even at higher prices with prospects for a further increase will enter the market, determined not to push the prices down. If oil prices fall significantly, the pace of growth in US production will slow down accordingly, albeit with a delay of several quarters (as producers hedge against the risk of price declines for a few quarters ahead).
• Putting a damper on rising prices will be gradual release of oil and liquid fuel stocks.
• A rebound in oil prices will give a considerable boost to the economies of oil exporting countries. At the same time, a moderate rise in oil prices should not harm consumer demand. As a result, global oil demand will grow by approximately 1.6 million barrels a day in 2017 (compared with 1.3 million barrels in 2016).
• In annualised terms, we project oil prices at just under USD 55 per barrel in 2017 and just over USD 55 in the following year (with the 2017−2018 average price of USD 55 per barrel).
• Risks affecting this projection include production in Libya and Nigeria, the two OPEC countries exempted from the deal. They both have spare capacity of oil production, which can be increased (or remain constrained) by several hundred thousand barrels a day depending on whether the internal armed conflicts are resolved or further escalate.
• We also believe another OPEC intervention in the oil market is possible in the second half of 2017, particularly if oil prices rise in response to the first intervention. Should oil prices fall, we will wait much longer for the next OPEC move.
• The exchange rate of the US dollar, which has gained significantly in value against the euro and emerging market currencies after Donald Trump’s election as the next US president, also plays a role in the oil price outlook. The stronger dollar is driving oil and fuel prices further up in those markets.
What we cannot see. We cannot see the number of upstream projects with average time spans of three to five years that were scrapped altogether in 2015 and 2016 or shelved until economically justified. Such abandoned or suspended projects will affect the rate at which production actually increases in 2018−2020, which may be slower than currently anticipated, given that production from existing fields declines by around 2.5 million barrels a day every year if no investment is made in well stimulation projects. The potential lost as a result of abandoned upstream projects is a big question mark, which may accelerate the upward trend in oil prices after 2018.