Bhamy Shenoy: Do we really know where oil prices will go?

(This article was first published in Industrial Economist)

Brent crude oil price after reaching a high of $110 per barrel in June of 2014, seems to have reached a floor price of $45/b this January. It has gone above $60/b. Despite earlier failure to predict oil prices, oil experts are again at it to predict where oil prices will go. Common person may get the impression that the oil experts can really forecast how the oil prices will behave.

When Brent was above $100/b at the end of 2013, most experts predicted only a small drop of $2 to $5 from the 2013 price of $109/b. There were some experts – though very few- predicted more than $10 to $20 per barrel. Not more than very few had anticipated a drop like the one in 2009 when brent had fallen below $50. Industrial Economist was one exception, and the article of March, 2014 had discussed the possibility of why it can fall below $50.

bhamy graph

Just like the current fall in crude oil prices, in 2008 after reaching a high of $145/b oil fell to $38/b (see Chart-1). However oil did not remain at that floor level for long. It took less than a year for it to reach a level of $75/b. After fluctuating at that level for few months, it started to increase again. After reaching $110/b it fluctuated around $100/b for three more years to fall below $50.b this year.

At the time of the 2008 crude price fall, the OPEC surplus capacity was above 5 million barrels per day (mmbd). According to an IEA estimate, current OPEC surplus capacity is about 3.40 mmbd and most of it concentrated in Saudi Arabia and Libya. All others are producing close to their maximum capacity.

IEA forecasts the world demand to increase by about 0.9 mmbd in 2015 and non-OPEC supply increase by 0.95 mmbd. Non-OPEC supply has already been reduced to reflect the drop in oil price. The resulting demand for OPEC oil will be around 29.8 mmbd. Given the adequate surplus supply capacity, it is easy to argue that prices are unlikely to stabilize over $50/b even though price has gone above $60/b.

In my view it is not possible to predict whether crude oil prices will bounce back as happened recently during 2008-2014 or follow the pricing development after crude oil prices collapsed from $36 lower prices (market has yet to decide) in 1986. It took over 18 years for prices to come to the level prevailing before the price collapse.

This is because an analysis of marginal cost for oil production for different types of oil (OPEC vs Non-OPEC, conventional vs non conventional, onshore vs offshore, shale oil in the US etc) that even below $40/b there will be enough production to meet the demand. A 2013 study done by London based Center for Global Energy studies had showed that 30% of the world production has less than $10/b marginal cost and 90% of the world oil production has less than $20/b of marginal cost.

Even more astounding results from a recent study done by another oil consultant, Wood Mackenzie has showed based on a study of 2222 oil fields around the world that less than 1.6% of the production will be unprofitable and would not be able to recover the cash cost. These marginal costs do show that world can manage to muddle through for few more years and remain around $50/b or even below that level.

On the other hand, margin of surplus capacity is not all that significant and 82% is controlled by Saudi Arabia. The avowed goal of Saudis to control supply is to pressurize costly oil producers to give up their projects to ensure higher market share for them.

However there are some who attribute Saudiʼs willingness to allow prices to collapse was to put economic pressure on the fragile economies of Russia and Iran to bring them to mainstream politics. There is also a possibility that Saudis might have adapted lower oil price policy to comply with the US request.

It is quite possible that the geopolitics could change and Saudi may start collaborating better with other OPEC and even with Putin if he offers to reduce production. Besides these factors some totally unexpected events to disrupt oil supplies as has happened in the past may take place and oil prices may shoot up. These factors are difficult to
foresee now.

As is often whispered in the international oil industry it is only the foolish or the genius who dare to forecast oil prices. It is not often one comes across the latter.

Dr Bhamy V. Shenoy, a retired senior executive with American oil major Conoco Philips, is a former adviser on oil & gas to the governments of Georgia and Turkmenistan