Global oil demand, supply and prices

It’s been almost enjoyable fuelling-up the car over the past few months. Prices have been dropping saving 25 – 30% on what I had been paying eighteen months ago. I live somewhat off the beaten track which means I don’t have access to gas supplies; oil central heating has been the only option. Filling up the oil tank has been much more satisfying. Heating oil doesn’t suffer the same taxation regime as transport fuel which mean that the lowered costs of barrels of oil (‘bbls’) have been far more noticeable. Combined with a milder, though wetter, winter than usual my current account is far healthier than it would normally be for this time of year.

The problem is that it doesn’t feel real. As with most of the developed world we have been inculcated with the notion that consumer prices should go and that 2% inflation is good for us. Creating 2% inflation has become a primary objective of most central banks; even the U.S. Federal Reserve joined that party a couple of years ago.

So what exactly is going on with oil prices?

There are several versions of history relayed by the media on this but they seem to distil into two broad themes. The first is one of supply, demand and price and the other relates to global politics.

The $140 price reached around the time of the 2007/8 banking crisis set the scene for more production but it was the reaction to that crisis that really acted as the catalyst for today’s low prices. The U.S. Fed printed money, QE (Quantitative Easing), and lowered interest rates to near Zero. The hundreds of $billions of ‘free money’ found its way into the U.S. energy sector coincidental with an accelerated development of ‘fracking’ technology. High oil prices encouraged lenders to pump money into the sector and produce. And produce they did. U.S. ‘tight oil’ or shale oil rocketed from a few hundred thousand bopd (barrels oil per day) of production in 2008 to well over 4m bopd by late 2014. You can see how this production turbocharged overall US crude production in the statistics here:

https://www.eia.gov/petroleum/production/

It peaked in spring 2015, also reflected in the statistics.

The nexus of politics and economics converge in the market reaction to this increase in U.S. production. OPEC saw this as a threat and Saudi Arabia are the biggest player in OPEC. Allegedly, the Saudis felt that ‘their’ market share was under attack and responded by increasing output to maximum with a view to influencing the price downwards and undermining the economics of U.S. shale production. It also had the added benefit of a poke in the eye of the Russians, also a major threat to Saudi production dominance. It worked. When combined with a recession in global activity in the Asia-Pacific markets a ‘glut’ emerged which naturally had a big effect on price.

Shale economics are complex. You don’t switch off a producing well overnight, even at prices well below profitable levels. And there is also the question of paying interest on those humungous debts accumulated during the ‘go-go’ years of shale expansion. ‘Hedging’ (selling forward) is also common in commodity markets and the shale producers had substantially hedged their output at contract prices extant prior to the price crash. Thus in 2015 while spot prices had plummeted many shale producers had been protected by their 2014 hedging contracts.

It’s getting complicated. My cheap petrol and heating oil seems to be tied-in with what will happen to the shale producers in 2016 and when the Saudis decide to reduce output.

On the former, it looks like only about 15% of shale production is hedged in 2016.

http://www.worldoil.com/news/2016/01/30/oil-and-gas-companies-face-difficult-year-as-hedging-protections-roll-off-ihs

Shale wells also deplete rapidly and the U.S. Fed is not as ‘accommodative’ as it has been in throwing ‘free’ money about. It does indeed look like U.S. oil production is going to fall somewhat in 2016, at least according to the EIA. The EIA has a rather optimistic outlook suggesting that overall output will drop from an average of 9.43m bopd in 2015 to 8.73m bopd in 2016 and 8.46 bopd in 2017. I suspect that the fall will be far more dramatic when you start to factor in the depletion rates for shale oil wells and an expected tranche of energy company bankruptcies during the course of the year.

Offsetting U.S. shale oil is Iran’s expected output. I have seen media comments projecting that Iran will add another 1m bopd over the course of the next year although traditionally the more experienced oil analysts have indicated that it will be more likely in the 200,000 to 400,00 bopd area. Let’s take the higher number. If this is the case the net effect of U.S. production decrease and an Iranian increase is still a decline of 300,000 bopd.

The last official world oil production statistic in the public domain is 96.2m bopd, the June 2015 figure also published by the EIA:
https://www.eia.gov/cfapps/ipdbproject/IEDIndex3.cfm?tid=50&pid=53&aid=1

Switching over to demand, the IEA (International Energy Agency) suggests that Q1 2016 demand will be 94.69 bopd, so the difference between world production and consumption is probably about 1.5m bopd.

But what is really interesting is that the Q3 and Q4 2016 IEA projections indicate that the demand will increase to 96.4m. In other words that wafer thin margin or ‘glut’ will evaporate during the course of the next six months, and we may even end up with a supply deficit.

My own view is that the decline will be greater and probably a little quicker than the forecasts suggests. We can’t guarantee that Iran will deliver 400,000 bopd nor can we guarantee that the Saudis will persist in maintaining maximum production. It’s not beyond the realms of possibility that oil prices will increase rather dramatically during the middle of the year and catch a lot of people by surprise. Anything is possible in our now highly interconnected world.

I think I’ll be filling that oil tank up long before winter this year.