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.
