Tuesday, 22 March 2016

Have oil prices bottomed out?

Signs that rebalancing in the oil market is underway.

Oil prices had fallen from the $100-plus level sustained over 2011-13. The reasons for the decline are also well-known: large new supply from US shale producers; OPEC’s refusal to lower production; and weak global demand in 2014. These have made the oil market over-supplied and led to a large build-up of inventories. But oil markets, like any other market, have a tendency to rebalance themselves. Incoming data confirm that the adjustment is indeed underway and could be behind the recent mini-recovery in oil prices to around $40 per barrel.

When markets are over-supplied, they tend to adjust in two ways. First, low prices push some producers out of the market as they become unable to cover their costs. This leads to a decline in supply, which should help the rebalancing. We are seeing evidence of this among the high-cost producers in the oil market, namely shale producers in the US. Production in the US has been in decline since it peaked in April 2015. And The Economist reports that further declines by more than 1 million barrels per day are expected in 2016-17.

The second adjustment mechanism is through higher demand. Low oil prices encourage people to increase their energy consumption by, for example, driving more and buying bigger cars. They also make the switch to oil from other energy sources more attractive. Again, the data support that demand is picking up. Last year saw the largest increase in global oil demand since 2010, which is impressive given that the world witnessed its slowest economic expansion over the same period. The boost to demand was purely due to lower prices.

So there are signs in the market that oil prices might have bottomed out. But two caveats apply. First, the adjustment is likely to progress only slowly given the large build-up of stocks that need to be cleared. Second, while some US shale oil producers are being pushed out, they have changed the landscape of the oil market. Unlike conventional producers, the response of shale companies to price swings is rather quick. If oil prices recover to around $50-60, shale could become profitable again, and production could soon increase as a result. This means that a world with $100 oil price might well be a thing of the past, and that oil producers should expect prices in the range of $50-60, at the very best.

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