After averaging nearly $US110 per barrel during the first half of 2014 and peaking at over $US115 per barrel in June, Brent crude oil has fallen by over $US40 in just a few short months.
Surging US supplies and lagging global demand in the second quarter were the proximate cause for the first phase of the sell-off. This set in motion an apparent change in OPEC policy, initially telegraphed in early September and clearly reconfirmed last Thursday, to allow for pure price discovery rather than a cut in production to stabilize prices. This prompted the second phase, culminating in last week’s plunge in oil prices.
With non-OPEC production growth exceeding demand growth, this revision to production guidance has removed the implicit OPEC 'put' from the market and has focused attention on the price at which other producers, namely North American shale producers, would begin to adjust output to rebalance the market. While surging North American production is contributing to an oversupplied physical market, we believe US production growth is still required to meet the approximate 1.3 million barrel-per-day (b/d) increase in demand we forecast for next year.
It is getting this balance of enough (but not too much) production growth from North America that will make 2015 a very interesting year in oil. While we see a high likelihood of pricing volatility next year, we also expect Brent to stay in the low $US70s on average, near current price levels but below the forward curve. That level should be sufficient to slow U.S. production growth but still meet market needs.
The OPEC factor
OPEC meetings are a time for the cartel to discuss production targets and offer guidance on its production policy to the market. But its 166th meeting on November 27 was more important than most given the pace of the previous sell-off and messaging from its leader, Saudi Arabia, suggesting it would be unwilling to shoulder any imbalance without broad cooperation from OPEC’s other members.
Orchestrating a broad cut was already tough to imagine, since the combination of diverging economic fortunes and growing policy and political differences has led to increasing dysfunction within OPEC in recent years. In the end, OPEC opted to leave the production quota unchanged and was unable to muster a word of support for oil prices, leaving high-cost shale producers, centered in the US, to shoulder some of the burden of adjustment.
Those who cannot remember the past are condemned to repeat it
This appears to be the third time in four decades that such a monumental change in policy has occurred, suggesting that the lessons from the 1980s and the subsequent 15 years of meager oil prices have been learned. More specifically, from 1981 to 1985, Saudi Arabia cut oil production by nearly 70 per cent in an attempt to accommodate other producers and support prices. However, over this period prices still fell by 25 per cent and per capita GDP in the kingdom roughly halved. In late 1985, Saudi Arabia changed course and increased production. Prices halved again, but at least income to the kingdom stabilised (see Figure 1).
The overarching lesson during this period was that by reducing production to sustain prices, both investment in alternative supplies (North Sea, Alaska, Gulf of Mexico) remained quite high and demand in the developed world suffered, leading to nearly 15 years of oil in the doldrums. By allowing prices to fall earlier in the cycle, OPEC appears to be trying to avoid repeating this mistake, in essence taking short-term pain for long-term stability.
Demand growth would help
This change in production policy is not without risks. For instance, there was an ill-timed OPEC quota increase at the end of 1997, nominally targeted to discipline Venezuela for overproduction and to expose other producers (namely Iran) that were claiming unachievable production capacity to support high quotas. This increase in output preceded the Asian financial crisis, which, when combined with a warm winter, proved toxic for oil prices – they subsequently halved until a coordinated production cut among OPEC, Mexico, Oman, Norway and Russia fixed the imbalances 15 months later.
A recovery in demand in 2015, which is our baseline, would go a long way toward helping heal the imbalances and support prices, but with the global economy outside the US on fragile ground, this outcome is by no means a certainty.
Threading the needle
The other primary risk to this change in production policy is that the responsiveness of US oil shale production has never been tested. Long lead times plus the high capital intensity of oil production elsewhere in the world leaves the North America energy patch as the primary non-OPEC producer with the ability to swing output in 'short' order.
Conventional wisdom is that West Texas Intermediate above $70 per barrel will be needed to sustain output, which makes current prices seem low. However, due to production costs being pro-cyclical (lower investment leads to lower marginal costs) and the incredible ability of U.S. producers to increase efficiencies, we believe marginal costs are unlikely to provide support to prices in the near term.
The US natural gas market is just one clear analogue that leads us to exercise caution and not bet against the ingenuity of US producers. The challenge is to determine what price level delivers enough US production growth to meet future demand growth but not too much as to materially eat into core-OPEC’s market share.
Given the reaction time from a change in price to a change in investment and, ultimately, production, it will be at least half a year before clarity is gained. We think US production growth of less than 0.5 million b/d at the end of 2015 would be a positive catalyst for prices (compared with current growth of over 1.25 million b/d).
Risks to the outlook are plentiful, but symmetric
Of course, there are plenty of risks to the forward outlook. Stability in key producers (Libya and Iraq) remains questionable, and pressure will build on others (Venezuela, Iran and Nigeria) as low oil prices challenge government budgets. In addition, low oil prices combined with European and American sanctions on Russia pose risks to Russian output, even if the fall in the ruble will help insulate domestic producers with the majority of costs in local currency.
On the downside, should US production growth slow less than expected, prices would need to move materially lower or OPEC would need to eventually act. This is a non-trivial risk, in our opinion.
Lastly, key OPEC producers could also survey the market conditions at any time and change their minds. While the far end of the oil curve has remained relatively well-anchored at $90/bbl, these risks, combined with OPEC not acting to reduce volatility, suggest the record low volatility of 2013 and the first half of 2014 is firmly in the rearview mirror.
Although we expect prices to average near current levels over the next 12 months, oversupply in the crude oil market will be a headwind to commodity investors due to negative roll yield. Holding an underweight to oil and moving length further out the forward curve could help mitigate some of these headwinds while still preserving most of the inflation hedging and diversification benefits sought by commodity investors.
Not all news is bad news for commodity investors, however, as the global economy should, on net, benefit from declining oil prices. While further deflationary impulses are unwelcome in regions where disinflation is already a problem, lower oil prices are undoubtedly a boon to the global consumer. Further, countries with subsidised oil prices will benefit from greater fiscal flexibility to support the local economy. Overall, these features should support oil demand as well as other commodities and, should the global economy truly heal, the stage could be set for better oil pricing in 2016.
© Pacific Investment Management Company LLC. Republished with permission. All rights reserved.