Oil - Four questions for 2015

A pickup in demand, a slowdown in shale oil growth, a cut from OPEC and a recovery in the oil price are expected in 2015

Oil had an eventful year in 2014. It rose all the way up to $115 in the first half of the year before collapsing spectacularly in recent months—it now stands close to $60. This post discusses four key questions which are likely to shape the oil market in 2015.

1. Will demand for oil pick up?

Yes. Growth in the demand for oil in 2014 was the weakest in five years—demand rose by only 0.6m barrels per day (b/d), according to the International Energy Agency (IEA). But demand growth is set to recover slightly in 2015 to 0.9m b/d on the expectation of higher growth for the global economy. The International Monetary Fund forecasts an increase in the growth rate of the global economy from 3.3% in 2014 to 3.8% in 2015. This is likely to have a positive impact on oil consumption. Lower oil prices are also expected to contribute to the demand increase. 

2. Will shale oil production slow down?

Yes. The rise of shale oil has been truly impressive. The US oil production is expected to increase by 1.4m b/d in 2014, mostly from shale. This means that the US has added the equivalent of the total production capacity of a whole country like Libya in one year. However, these gains are expected to slow down as lower oil prices make some shale projects unprofitable given the high costs of extraction. Some shale firms have already announced cuts in their investment spending for next year, while others are expected to follow suit in January/February when they unveil their investment plans. As a result, the US oil production growth is expected to slow down to 0.95m b/d in 2015.

3. Will OPEC cut its production?

Yes. The latest OPEC forecasts, published a few days ago, suggest that a cut is probable. These forecasts indicate that OPEC might need to cut 1.1-1.4m b/d from its crude oil production of 30m b/d to balance the market and remove the excess supply (see Table 1).

OPEC will probably wait until significant reductions in the investment spending of shale oil firms have been announced before embarking on a cut of its own. This means that it is unlikely to act before February but could potentially step in before its next scheduled meeting on 5 June 2015. Therefore, the date of the OPEC cut could be sometime around the second quarter of 2015.

4. Will oil prices recover?

Yes—if we assume a pickup in demand, a slowdown in shale growth and a cut from OPEC. Even then, things might get worse before they get better. The market is likely to be oversupplied in the first half of 2015 (see Table 2 where I modify the IEA’s projections using my assumptions).

The implication is that the average price of oil is expected to be around $60-70 in the first quarter (Q1) of 2015, before reaching a low of $55-65 in Q2 as inventories build up. A seasonal recovery in demand and a slowdown in supply growth in Q3 are projected to lead to a drawdown of inventories, with the price recovering to around $65-75. The momentum is expected to continue into Q4 when the price is forecast to settle near its equilibrium level of $75-90. Overall, the oil price is expected to average $69 in 2015.

Will oil price stay “low”?

If the new consensus is right, the era of a triple-digit oil price is over

Oil price has fallen to around $80 per barrel from its peak of $115 in mid-June. While the new price is not particularly low by long historical standards, it does seem low in comparison with the recent past given that it had stayed above $100 for most of the three and a half years prior to the fall. So is the recent sharp fall a result of temporary factors or a reflection of deeper fundamental forces in the oil market?

A new consensus has emerged arguing that a below $100 price is the new norm. The view suggests that changes in the landscape of the global oil market—particularly on the supply side—are leading to a lower equilibrium price, estimated to be in the range of $80-90 per barrel. This view is based on three propositions about the market over the next few years.

1. The US oil production will continue to grow, mostly due to shale oil. The shale revolution is reducing the US reliance on imported oil, creating oversupplies elsewhere. While this process has started in the mid-2000s (see the chart), other factors were at play keeping global oil price high (demand from China and other emerging markets, supply disruptions in the Middle East and so on). With these factors receding, the continuous growth of shale oil is expected to keep oil price lower than in recent years.

2. Shale production will still be profitable at the new equilibrium price range. Shale oil is costlier to extract, but the process is becoming more efficient. While there is a great deal of uncertainty about the minimum price at which the extraction of shale oil is profitable for producers, the new consensus suggests that it could be around $80. This means that at the new equilibrium range of $80-90, shale oil is expected to continue growing, although at a slower pace than in the last few years. Only a sustainable drop of oil price below $80 would make some shale investments not viable leading to production cuts.

3. There will be no supply shocks (positive or negative) from the Middle East. The new consensus assumes modest production growth in Iraq (0.2m b/d each year) and a stabilisation of Libyan production at around 0.7m b/d. It also assumes no production growth in Iran.

Given these assumptions, the new consensus expects oil to trade mostly around its equilibrium range of $80-90, with possible temporary deviations due to the occasional build-up of inventories or exceptional weather conditions.

There are risks to this view. On the downside, further decline in shale production costs or a lifting of the sanctions on Iran could result in more global supply and a further decline in price. On the upside, supply disruptions in Iraq or Libya could lead to a higher price, as could an aggressive reaction by OPEC to the price fall.

OPEC is meeting on 27 November and observers are evenly split about the likelihood of a production cut. But even if the organisation surprised with a production cut, it is not clear if its action would be enough to turn the tide caused by the shale revolution. If the new consensus is right, the era of a triple-digit oil price is over.

Iraqi oil from propaganda to reality

A series of revisions to production targets will result in lower oil output from Iraq than originally planned.

On 4 September, Iraq reached an agreement with BP and the Chinese oil company CNPC to lower the planned production target for Rumaila, the country’s largest oil field. The agreement is not a one-off—it is part of a series of revisions to the targets that had been originally agreed on with international oil companies in 2009. The revisions will lead to a sharp fall in Iraqi oil output relative to the original unrealistic plans.

The BP/CNPC deal does not come as a surprise. For months international oil companies have been negotiating lower production targets for the fields they run. ExxonMobil agreed with the Iraqi government on a lower production target for the West Qurna-1 field. Lukoil did the same for West Qurna-2. Likewise for Eni and CNPC, the operators of Zubair and Halfaya, respectively. Only Shell is yet to agree with the Iraqi government on a new output target for the Majnoon field. It is lobbying for a reduction from 1.8 million barrels per day (mb/d) to only 1.o mb/d, but the Iraqi government is holding out for 1.2 mb/d. (The table below provides a summary of the original and revised production targets by field.)

Such broad revisions to the original agreements indicate a flaw in the way the contracts had been awarded. The process involved oil companies submitting bids specifying: (1) production target (the peak level of output the company would eventually produce from the field); and (2) remuneration for developing the field and reaching the target. Iraq then chose the bids with the highest production targets (since they result in more revenue) and lowest fees (less cost). But as pointed out by James Hamilton, these auctions encouraged oil companies to exaggerate production targets in order to win the contracts. Once awarded, they began negotiating lower targets to move from “propaganda to the reality”.

What does the new reality hold for Iraq? The path of future Iraqi oil production will be significantly lower than originally planned. Instead of producing 11.0 mb/d from the six fields listed in the table above by 2020, Iraq has to settle for only 7.2 mb/d. And even this target looks overly optimistic. To achieve it, Iraq has to be more stable and efficient in the next six years than it has been in the last five.

The production loss is even bigger if we include the fields of Qayara and Nejma, which were projected to add 230 kb/d by 2020. Sonangol, the Angolan company which had won the contract to develop them, pulled out of the country in February due to deteriorating security situation. The fields are now under the control of the Islamic State of Iraq and al-Sham, and there is little hope for production growth from either of them.

Finally, while BP/CNPC were not alone in negotiating a revised production target, the agreement unusually included raising their shares in Rumaila. BP’s share increased to 47.6% and CNPC’s to 46.4%, while Iraq’s stake was reduced to 6%. Iraq had previously maintained a 25% share in all oil fields, and it is not clear whether this reduction is unique to the BP/CNPC agreement or if it also applies to the other revised deals. Iraq might be moving from propaganda closer to reality, but transparency is still in short supply.

Who controls Iraq’s oil?

The conflict in Iraq is unlikely to materially reduce oil production but could lead to a significant slowdown in its growth.

The International Energy Agency has released the full text of its monthly Oil Market Report. The report raises interesting points about the current state of Iraqi oil production, some of which I discuss below.

                                 Source: International Energy Agency

1. Iraqi oil production continues unabated, despite the ongoing violence. Officially, Iraq's daily oil production averaged 3.1 million barrels per day (mb/d) in July. Oil fields in Kirkuk pumped 0.16 mb/d; the Kurdish Regional Government (KRG) produced 0.31 mb/d; with the southern fields responsible for the remainder of production at around 2.65 mb/d. 

2. By capturing Kirkuk, the KRG has doubled the production capacity under its control to around 0.85 mb/d. However, logistical constraints and political/legal disputes with the central government in Baghdad has kept production at half capacity.

3. Logistically, the KRG does not have the infrastructure to refine or export additional oil production. Fighting around Baiji has resulted in the closure of Iraq’s biggest refinery—with 0.3 mb/d capacity. Furthermore, the Kurdish private pipeline, which has been used to transport independent Kurdish exports, can accommodate current Kurdish exports but very little on top of that.

4. The dispute with Baghdad over independent oil exports has made it difficult for the KRG to find international buyers. Of the six KRG cargoes which have left the Turkish port of Ceyhan since May, only one has managed to offload its contents—at the Israeli port of Ashkelon. Another cargo is a subject of a legal dispute before a US court between Baghdad and the Kurds. The rest are still in limbo.

5. The Islamic State of Iraq and al-Sham (ISIS) has added Ain Zahla and Batma to its existing portfolio of oil fields, which consists of Najma, Qayara, Himreen, Ajeel and Balad. This means that ISIS controls 80 thousand barrels of daily oil production in Iraq alone—equivalent to 2.6% of the total official Iraqi output (including the KRG).

6. Oil production and smuggling has been reportedly providing ISIS with $2 million a day. These reports are not backed by hard data but they seem plausible if we assume that ISIS is producing at 50% of capacity (40 kb/d) and selling crude at half price ($50 per barrel). It also means that losing the oil fields could deal a significant blow to ISIS by depriving it from a valuable source of funding.

7. Southern oil accounts for 85% of Iraqi production and all official exports. Southern production and export facilities are quite distant from the conflict zones in the north and west of the country, and have been immune from sabotage. In the short term, violence is likely to have limited impact on Iraq’s ability to pump and export oil.

8. In the medium term, violence could have quite a negative impact on oil production and exports. First, the general deterioration in the country’s security situation could lead to a disruption in foreign investment and missing out on ambitious production targets. Some companies, such as BP and ExxonMobil, have already withdrawn non-essential staff. Second, trade partnerships are likely to be tested, with China and India—the largest importers of Iraqi oil—pre-emptively looking for supply alternatives. 

Egypt’s inflation accelerates in July

Inflation in Egypt increases to 10.6% and is set to rise further as the full impact of the cut in subsidies is realised.

July inflation data for Egypt were published yesterday. These are the first figures on inflation following the government’s decision to reduce its energy subsidies early last month. The headline figure showed annual inflation accelerating from 8.2% in June to 10.6% in July. Monthly inflation—where the effect of subsidy reduction is more pronounced compared to the annual number—was 3.1%, the highest increase since January 2008. Looking at the drivers of this figure, three things stand out.

First, the direct impact of subsidy reduction on prices has been lower than expected. For example, the “housing, water, electricity, gas and fuel” component of inflation rose by only 3.0% in July, despite double-digit price hikes for several energy products. Similarly, the “tobacco and related products” item rose by 14.1%, less than expected given the government’s recent decision to increases taxes on cigarettes and alcohol. (See this for a list of cigarette prices before and after the tax increase.) If the inflation figure for July has not fully captured the effect of energy subsidy reduction and tobacco tax hike, then we should expect further increases in the prices of these two components next month. 

Second, the second round effects of the tax/price hikes are yet to be fully realised. For instance, “transport” costs rose by 11.2% in one month from June to July reflecting the rise in fuel prices, while prices at “hotels, cafes and restaurants” rose by 4.4%. Prices of these two components might rise further after the full incorporation of higher energy prices, implying additional contribution towards inflation from these two categories in the future.

Third, food price inflation in Egypt accelerated to 2.7% despite recent declines in international food prices. This rise could be only temporary due to the effect of Ramadan, and we might see a moderation in this component going forward.

In this sense, Egypt has been quite fortunate that the reduction of subsidies coincided with falling international food prices. Things could have been a lot worse if energy price increases were coupled with food price inflation similar to the one witnessed in mid-2008 or 2010, especially with food accounting for 40% of the consumer price index basket.

Overall, annual inflation will probably increase further as the direct and indirect effects of energy and tobacco price increases get fully incorporated, notwithstanding lower food price inflation. This is unlikely to spur the Monetary Policy Committee (MPC) of the Central Bank of Egypt into further action in its next meeting. Instead, the MPC may choose to wait and see if its pre-emptive interest rate hike last month would prove sufficient to curb inflation. 

Egypt faces the risk of stagflation

Egypt cut energy subsidies and faces the unenviable prospect of depressed output and high inflation.

On 5 July 2014, the government of Egypt reduced its subsidies to fuel and electricity leading to a price hike in these products. The government has also announced its intention to remove subsidies completely within the next three to five years. This comes among a set of other measures aiming at reducing the large budget deficit which is becoming harder to finance. While the motivation behind reducing subsidies is understandable, its likely outcome is stagflation—a period of stagnant economic activity and high inflation.

The impact on activity is straightforward. Higher energy prices mean that people have less of their income available to spend on other items. The resulting fall in demand leads to lower output and higher unemployment.

The effect of higher energy prices on inflation however is more multi-layered. First, fuel and electricity are included in the basket of goods and services from which inflation is calculated, so their higher prices directly result in higher inflation. There is also a second round effect as higher energy prices imply a higher cost of production in transportation and industry, which is likely to be transmitted into higher prices for final goods as producers try to maintain their profit margins. This leads to a further rise in inflation.

There is, in addition, a third round effect: If the higher rate of inflation is expected to persist into the future, workers will demand a pay rise by an amount equal to expected inflation to keep their real incomes from falling. Higher wages mean a higher cost of production which in turn leads to the higher prices initially feared by workers as their expectations become self-fulfilling.

While the first and second round effects on inflation are inevitable, the third one is not. If people expect the price increase to be a one-off event, then it will not pass through to higher wages and prices and inflation will quickly fall. But if they do not expect inflation to reverse, then this will lead to wages and prices chasing one another resulting in runaway inflation. Getting one outcome or the other depends on people’s expectations about the future path of inflation and how serious policymakers are about bringing it down.

Which brings us to the recent move by the Central Bank of Egypt (CBE) to raise interest rates on 17 July.  The CBE is clear in its statement that the upward revision to energy prices with its direct and indirect impact on inflation was behind its decision. The CBE raised interest rates in order to “anchor inflation expectations and hence limit a generalised price increase, which is detrimental to the economy over the medium-term.”

Raising interest rates should encourage saving and reduce consumption and investments, hence contain inflation. But a by-product of that policy is an even more depressed output and higher unemployment. This is a price the CBE seems willing to pay to keep a lid on inflation. Whether the CBE’s action and tools would be enough to achieve its aim is something to be seen and observed.

A bloody June in Iraq

Iraqis left physically unharmed by violence may still have an economic price to pay.

Iraq witnessed its bloodiest month in June since the height of its civil war in the summer of 2007. Preliminary data show that almost 2,000 civilians have died as violence gripped the country. The figure would rise significantly if casualties from the Iraqi security forces were also included. Not only does increased violence threaten the physical safety of Iraqis, it also adversely impacts the economic well-being of those fortunate enough to survive unharmed.

Data on casualties from violence in Iraq come from two main sources. The United Nations Assistance Mission for Iraq (UNAMI) publishes statistics on civilian and security forces casualties based on witness reports as well as evidence from civil leaders, government officials, international organisation, media reports and the UNAMI own network in Iraq. The figures released by UNAMI show that 1,531 civilians and 886 members of the Iraqi Security Forces were killed in June. These numbers exclude deaths in the Anbar province, where the UNAMI estimates further 244 civilian deaths. The figures make June comfortably the bloodiest month since UNAMI started publishing its statistics in January 2008.

The second source is Iraq Body Count, a project to record civilian casualties in Iraq since 2003 based mainly on verifiable media reports. Its preliminary estimate for civilian casualties in June stands at 1,934—the highest number since August 2007, or the heydays of the civil war. The data also show that 2014 is on track to become the most violent year outside 2005-7.

Unsurprisingly, increased level of violence tends to take its toll on economic activity. In recent years, higher levels of violence in Iraq were associated with lower economic growth. As the chart below displays, 2007 was the second most violent year and also the year which witnessed the slowest growth rate. In contrast, the relatively peaceful years of 2009-12 saw some of the highest levels of growth. Only 2006 stands out as an outlier with both high levels of violence and a fast-growing economy.

What does that imply about growth in 2014? If the levels of violence seen in the first half of 2014 were to continue into the second half of the year, 2014 would be the most violent year outside the 2005-7 period. Should the impact of violence on the economy be similar to the one witnessed in recent years, then we should expect real GDP growth of 4.4%.

Alternatively, a more tragic scenario in which the elevated levels of violence in June continued for the rest of the year would result in 18.5 thousand civilian deaths, making 2014 the third most violent year after 2006-7, the peak of the civil war. Under this scenario, real GDP would grow by a mere 3.1%. Given that population is also expected to grow by 3.1%, this would imply stagnant economic conditions for the average Iraqi.

So what are the economic costs of increased violence? The International Monetary Fund had recently forecast real GDP growth of 5.9% in 2014, the recent rise in violence would probably shave off 1.5-2.8% from this year’s real GDP—a significant cost for a country still lagging behind in terms of goods and services provided.

It means that Iraqis who were fortunate enough not to lose their lives or get injured during the recent violence may still have an economic price to pay.