Can oil prices be predicted?

Can oil prices be predicted?

It is a truth universally acknowledged that the future cannot be accurately predicted, and the same applies to oil prices. In the latter case, however, it is possible to consider alternative scenarios pertaining to certain fundamental factors which, while rather inert in a short-time horizon, can be shaped in the long term.

These scenarios may be assigned subjective likelihoods of materialisation depending on our assesment of supply and demand trends. However, the downside to scenario analysis is that it, obviously, ignores unpredictable future factors which may significantly affect supply and demand, and thereby the prices of oil. For this reason, future prices elude easy prediction. Still, scenarios for the market development in the mid- and long-term remain one of the cornerstones upon which oil companies build their strategies. In my previous blog entry, I presented a base-case scenario, that is one considered the most probable. Now I will explain why we still think that way.

Firstly, the problem that the oil market has been struggling with since mid-2014 is excess supply rather than shortage of demand. Accordingly, the situation is vastly different from what it was towards the end of the last decade. I have already discussed the causes of the excess supply and why it came as a surprise  In any case, according to IHS estimates, in 2014 the output exceeded 2013 values by 2.1 mbd. Supply from non-OPEC countries soared by 2.3 mbd, while OPEC’s production declined by 0.2 mbd. However, the growth in output was not matched by demand, which went up by a mere 0.6 mbd (representing less than a half of the 2013 growth). The 1.5 mbd oversupply coupled with a reversal in OPEC’s strategy involving non-intervention to curtail output left the market with no alternative but to adjust prices.

The peculiar thing about the physical oil market (supply and demand) is that it only reacts to price drops when they sustain for several quarters. The mainstay of demand for oil has always been the transport sector, where petroleum-based fuels do not have any close substitutes, which suppresses short-term price flexibility of demand. Hence, demand does not immediately align itself with prices, rather the process is triggered by changes in disposable income which remains after transport costs are subtracted. If the price of fuel goes down, these costs diminish leaving more disposable income. However, consumers are not quick to alter their transport habits and react only after lower fuel prices persist for two to three quarters, prompting them to switch from public transport to cars, carry more goods by road instead of using other means of transport, and finally, buy more cars. According to estimates, over a half of additional disposable income attributable to low oil prices ultimately makes its way to the oil market anyway, driving up demand. Moreover, adjustments on the supply side are also slow to manifest and require an extended period of low prices (several quarters). This stems from the common industry practice to hedge future production against price declines, while decisions to green-light new upstream projects are based on expected future prices. The appreciation of the US dollar against other currencies, which has accompanied the decline of oil prices, muffled the price signals reaching non-US producers and consumers, and repressed the adjustment process. Furthermore, the first half of 2015 saw increasing oil prices driven by mistaken interpretation of the drop in the US drilling rig count.

Six quarters of falling oil prices have already triggered adjustments on the oil market. This trend is expected to continue for another two to three quarters, leading to excess demand and price hikes. According to preliminary estimates, last year’s demand for crude oil and liquid fuels grew by 1.7 mbd as compared with 0.6 mbd in 2014, surprisingly − against the background of a global GDP slowdown. In 2015, supply continued to grow, but the increase in non-OECD countries (by 1.5 mbd) represented only a third of what it was a year earlier. OPEC countries boosted production by 1.2 mbd further adding to the pressure on prices. Due to low prices anticipated for the better part of 2016, production in non-OPEC countries (primarily in the US) should continue to dwindle, on a trend started in the second half of 2015. Total supply should remain more or less flat on 2015, even if OPEC producers (chiefly Iran) decide to increase output. While the anticipated excess demand in 2016 (of 1.2 mbd) will still fall short of absorbing the backlog accumulated over the two previous years, the prospect of an upturn in demand with a 50% lower supply growth gives substance to the expectation that in 2017 demand will finally outstrip supply.

Before the market sees light at the end of the tunnel, the spot price of oil will still be governed by a fairly random process, the outcome of which is like a roll of dice - completely unpredictable. Whenever the stream of oil flowing into the market greatly surpasses the outflowing stream of demand, the spot price of already produced oil will remain affected by the costs of clearing it from the market, which have little in the way of actual production costs. In such circumstances, the main factors influencing prices are speculative demand (buying to sell and profit) and storage costs. This segment of demand, dominated by financial entities, reacts in real-time to any new piece of information and incites constant, multi-directional movements in market prices, hindering adjustments (reduction of any surplus) in the production potential.

The scenario for oil market developments describes the price rise mechanism but fails to point to specific values, since this depends on a multitude of factors which, at this point, are largely unknown. Such an element on the demand side may be a sharp economic downturn (China) or recession in developing countries (South America) related to fiscal tensions spurred by the extending horizon of low oil prices. Yet looming are other elements that may further stretch this horizon − Iran’s return to the market proving more pronounced than currently anticipated or higher resilience to price drops of oil originating from unconventional sources. A combination of these factors may carry the low price horizon beyond 2016.

The International Energy Agency has already tested the likelihood of the scenario whereby low oil prices remain low until 2020. The IEA has found that for prices to remain low over the next couple of years an unlikely coincidence is required of slower economic growth until 2020, marked acceleration in the withdrawal from subsidising fuel consumption in OPEC countries, greater resilience of non-OPEC producers in a low price environment, and above all, determination from the cartel itself to follow the strategy of prioritising market share and low prices, which prevents oil being supplanted by other energy resources. Under this scenario, a higher demand for oil could only be satisfied through quick investment in expanding the production of cheap oil in the Middle East (a marginal cost of USD 30/b covering the entire cost to find and develop an oil field, and the cost of production). Without such investment and a major increase in production that would push OPEC’s share in oil supply to levels last seen in the 1970s (over 50%), the price would have to grow before 2020 to balance the market. The IEA considers the low price scenario to be very unlikely over the span of the next few years.

To quench the thirst for oil and liquid fuels, production must exceed the rise in demand several times over. This is caused by the gradual depletion of producing fields. The decline in output from such fields until 2040 will exceed the growth in demand for crude oil and liquid fuels several times. In its latest 2015 edition of the World Economic Outlook, the International Energy Agency presents a New Policies Scenario which predicts how the global energy sector could develop if politicians were determined to implement all their climate policy commitments. According to this ‘green’ scenario, demand for oil and liquid fuels (without biofuels) would only increase by 13 mbd (0.5 mbd annually) until 2040, which is well below market projections. However, just to offset the diminishing output from producing conventional fields until 2040, 43 mbd of oil from new fields would be required.

As new deposits are increasingly difficult and expensive to develop, the price of oil must be high enough to ensure profitability at premium cost.