RGE Monitor, Rachel Ziemba | Sep 11, 2008
Since mid July, Crude oil futures have fallen almost $50 from their peak, WTI is in the neighborhood of $100 a barrel, and Brent has already closed below $100 a barrel. About two months ago, I suggested that we were finally seeing the fall in oil prices I’d been expecting to see for some months. Since then demand destruction has taken the upper hand, as it became clearer that a slower global economy would erode demand growth as it has already done in the OECD. However it is a sign of the frothiness of the market that it took only a relatively small decrease in demand to trigger this look back at fundamentals. The oil price also reflected the more general reassessment that led to a USD rally against the Euro and Pound.
So where is the oil price heading?
This week, OPEC stepped in – to in part – try to steer the market to a oil price floor. OPEC’s additional oil supplies (mostly from Saudi) had contributed to putting the oil market well in surplus where supply exceeded demand, contributing to lower prices. OPEC had been pretty absent as an actor in the oil market in recent months, with Saudi Arabia taking the lead on adding new supplies, convening a special oil conference in June.
The impact of OPEC’s cuts back to September 2007 levels will be a matter for coming months – and assumes that all members including Saudi Arabia will agree to return to those levels. The latter assumption may not be valid. The New York Times suggests that Saudi Arabia may not return to past production levels. It is particularly unlikely to do so until it gauges winter demand – in part because it does not want to be blamed for exacerbating economic woes or pricing its product beyond the means of its purchasers.
In the short term the combination of removal of supply and hurricane risks could be a bit bullish for oil. Yet, supplies have been sufficient that despite the threat of real supply shocks, oil has failed to hold gains. And given the outlook for the U.S. economy, it doesn’t seem likely demand will pick back up. Especially since even the threat of real supply disruptions failed to have that effect. And investors whipsawed on the way up and down in the energy markets might not want to get back in. Meanwhile new regulations might make it somewhat more difficult to borrow to trade.
So all in all, it points to oil in the double digits soon. Yet, there could be a pretty high floor for oil – perhaps $80 a barrel. Such a price is still high (higher than 2007’s average of around $71), even if it seems cheap after flirting with $150 a barrel.
UPDATE: However, given limitations on supply, we could see an oil price rebound when (and if) the U.S. and global economies recover. Given that the supply additions, particularly from non-OPEC sources is limited in the near term, we could see a gradual climbing after 2010. But we might not see the kind of trajectory we saw this year unless the same credit constraints and liquidity traps recur as they did this year. However, I should add that my $80 price point is slightly arbitrary and sentiment matters a lot END UPDATE Why that price point?
1) There still isn’t that much supply. While Saudi Arabia added new supplies from Khursaniyah, boosting its surplus capacity, there aren’t a lot of new supplies from either OPEC or non-OPEC members coming online in the next few years. Following a global recession-induced demand slowing, we could see a mid-term tightening of supplies. 2) The cost of a marginal barrel of oil has risen along. Certainly many unconventional oil sources need about $70 to break even. And countries about to put in motion more investment may want to ensure their investment will pay off. Of course some supplies are still cheaper than others, production costs in the gulf are lower than in many areas, but many of the touted new supplies from Brazil’s Tupi or others are in the neighborhood of $50 a barrel break even costs. Supplies and investment programs that became viable at over $100 a barrel may seem less attractive if oil crosses the double digits
3) At a certain price point, Americans (and others) will start consuming more again. And perhaps if credit eases, Chinese might start buying cars again. While some behavioral changes will stick – you don’t go returning the fuel efficient car for a gas guzzler – others, like a switch to carpooling or public transport, may not. That price point could be in the neighborhood of 70-90 a barrel. I base this on the fact that when oil averaged $60-70 a barrel in 2006 and 2007, few of these behavioural changes had taken effect yet. Demand is price dependent.
Finally, more and more oil exporters (OPEC and non-OPEC) need an oil price of around $60+ a barrel to pay their import bills. Ahead of the OPEC meeting, I updated some estimates of the spending and saving patterns of oil exporters. This partly updates a paper I wrote over a year ago, when $70 a barrel seemed kinda high.
A quick caveat – a history lesson of the 1980s would show us that oil exporters can’t keep oil prices high just by wishing it so. OPEC’s role is clearly significant, especially not that it accounts for much of the incremental supply, but it may be limited in its activities. In general, OPEC, and other cartels have tended to be more effective at pushing prices up by restricting production than bringing it down. Furthermore, if oil prices continue to slide, the determination of OPEC may be tested as some producers may prefer to sell more volume to maintain a certain revenue inflow – contributing to more supply and lower prices.
UPDATE: The following is hypothetical scenario to illustrate the spending patterns of oil exporters. It doesn’t necessarily mean that oil will stabilize at $80 in the next few years, but rather shows the vulnerabilities that oil exporters might face if it does. These vulnerabilities, could contribute to OPEC members actually pumping more oil in order to increase revenues. And the trajectory may not be clear END UPDATE My calculations assume that oil averages $110 a barrel this year and $80 a year thereafter, that oil output remains similar to that of the spring of 2008 (ie before Saudi Arabia’s increase) and that spending (imports) and non-oil exports continue to climb at current trends. Assuming that oil stabilizes at $80 a barrel, these spending patterns would slow, but it is easier to scale up than to scale down spending (another lesson of the 1980s).
Under these assumptions, the current account surpluses of all key oil exporters would erode considerably – meaning that surpluses in 2009 would be lower than in 2007, when the oil price was slightly lower.
See the following estimate of GCC spending and saving ratios. This graph shows the share of each barrel of oil that is spent and what is saved. It uses a broad definition of imports and nets out non-oil exports to show what imports need to be paid from the oil revenue intake.
In aggregate, oil exporters might soon start spending their savings – and some countries will have to do it sooner than later – and in aggregate oil savings will still be large. Oil exporter current account surpluses would likely be close to $300 billion in 2009 under the scenario I’ve depicted, still a lot less than the over $600 billion in 2008 but nothing to sneeze at. Furthermore oil savings actually exceed the current account surpluses in some cases as private capital inflows to countries like the UAE, and Russia have eroded the current account surplus, meaning that oil savings outstrip the net savings of the country.
Again the following graphs are somewhat hypothetical, especially as its difficult to forecast out spending rates.
Some countries will have non-oil exports to cushion the effect of falling prices. Others are more vulnerable. The bigger spenders include Oman, Kazakhstan, Iran, Venezuela. But even more fiscally conservative (until recently) countries like Kuwait and to a lesser extent Saudi Arabia, will have surpluses erode as fiscal spending begins to outpace revenues. This in my view will contribute to an oil price floor.
Data – IMF, adjusted by Author
Russia attended the most recent OPEC meeting and suggested more cooperation with OPEC – a rather political statement to be sure and fitting in with its putting trade talks on the back burner. Russia need not actively participate in OPEC to support its goals. Russia’s declining oil production (down more than 1% from last year and the first decline in 10 years) means it is unlikely to be a spoiler to OPEC.
So we may be in for expensive energy for some time to come – however, recent prices are clearly a relief for the global economy, which was suffering even at $120 a barrel oil – even if not for the planet.