The rise and fall of oil price

Commodities , Energy , Oil , Saudi Arabia , USA Oct 20, 2014 No Comments

Oil productionThe price of oil has plummeted by more than a quarter since June but will Opec, which holds 60% of the world’s reserves and 30% of supplies, cut its own production to try to lift prices?

Will the cartel allow a further slide from the current price, which fell to just under $80 a barrel at one point last week, in the hope of making it impossible for US drillers to make a profit from their wells, and so driving them out of business?

There is a surplus of geopolitical risk in the world, but a greater surplus of oil. Something had to give, and that something has proved to be the oil price. Its dramatic 25%t plunge reflects the reality of a new era in world oil, one defined by a resurgence of North American supply.

According to Oilprice.com, there are 5 reasons oil prices are dropping:

  • The US shale oil boom
  • Lybia‘s unexpected rapide return with 810,000 barrels a day in september
  • OPEC infighting with Saudi Arabia defending its market share in an oil price war
  • The EU economic outlook with a growth forecast decreased to 0.8% for 2014 by the IMF
  • Reduced Asian demand because of slow economic growth, currency depreciation and decreased energy subsidies

Oil production

Although some in Europe and the Middle East are skeptical, the revolution in American shale gas and tight oil is real. US crude oil output is up almost 80 per cent since 2008, supplying an extra 3.9m barrels a day – more than is produced by any of Opec’s 12 members except Saudi Arabia. Canadian oil sands have added another 1m barrels a day to North American supply over the same period.

However, critics say that production in the very formations that are most responsible for the U.S. oil boom is endangered by two major factors: a lack of infrastructure at home, which makes the storage and refining of crude more complicated than it should be, and the potential for the oil price to plummet further if the OPEC doesn’t cut its output.

“The market has gotten oversupplied, and with the potential for domestic prices to fall by another $6-$8, certain unconventional plays are no longer economic to develop,” said James Fallon, director of research and consulting with IHS energy team. “So producers aren’t going to keep putting money into developing and completing new wells, and so they will just stop drilling and that will slow down production,” Fallon said, despite the fact that the Energy Department last week reported that only 4 percent of shale production in North Dakota, Texas and other states needed an oil price above $80 a barrel for producers to break even on investments.

The collapse in oil prices is already a major cause of concern for countries heavily reliant on exports of the commodity. For some, it could be a matter of avoiding a severe recession. For governments in oil-exporting countries to meet their spending commitments they need oil to remain above a certain price. With oil prices around $80~$85 a barrel, countries that rely on high oil prices, including Venezuela, Russia, and, to a lesser extent, Saudi Arabia, may have a reason to be concerned. Venezuela, for example, literally needs the price of oil to double to keep its house in fiscal order.

As Goldman Sachs wrote in a recent note: there is a realization that the OPEC reaction function has changed and that the US shale barrel is now likely the first swing barrel. When Saudi Arabia cut prices to Asia for November delivery it was interpreted as a shift in the Saudi reaction function to a focus on market share. This should have not been a surprise in the new world of shale that has flattened the supply curve, as economic game theory suggests that they should not be the first mover and that the US shale barrel should be the new swing barrel given how easily it can be scaled up and down.

For the world economy as a whole, if the oil price was to stay in the current range, it would mean the equivalent of a huge quantitative easing program, helping to spur stalling economic growth. The decline in prices would generate a $1.8bn daily windfall, about $660bn annualised. Tracking this into gasoline prices, in the US, where last year some $2,900 per household was spent on gasoline, the windfall would amount to a tax rebate of just under $600 per household. It would affect all consumers globally save for those in Opec countries, who already pay little for fuel.

Oil and gas producers are currently hammering out their budgets for 2015, so analysts and investors will be paying keen attention to the mood of top brass on quarterly conference calls and looking for signals about how oil market volatility may affect future plans, said Lanny Pendill, an analyst with Edward Jones in St. Louis, Mo.

Oil prices could rise yet again, stoked by new disruptions. They surged, after all, early this summer, when Isis emerged as a potential threat to production in the south of Iraq, where the bulk of the country’s production takes place. But that did not last. Once it became apparent that this infrastructure was secure, at least for now, the price eased.

Pascal Blanc

Pascal has implemented numerous software solutions in the areas of procurement, sourcing, spend management, supplier evaluation and performance. His clients include Fortune 500 companies in Europe, Asia and North America. He is a co-founder of Source & Procure.

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