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Oil market: Dramatic and fundamental change

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OPEC’s decision to allow the oil price rather than its own output policy to balance the market is a new strategy that fundamentally changes the oil market. The next few months are likely to be highly volatile. 


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After three years of stable oil prices of around $110 a barrel, prices have plunged more than 40% in five months – while there has been only a small shift in underlying supply and demand. It seems that the market is finally catching up with a fundamental shift that has been playing out for years.

US shale oil production has constantly surprised to the upside over this period, while the sustainability and implications of this development were not taken in. Wood Mackenzie estimates that the Eagle Ford shale in South Texas has produced more than one billion barrels of crude and condensate since 2008, of which 70% has been produced over the past two years. Production next year is estimated to be 2.8 mbd – in line with the major OPEC producers.

At the same time, there has been a slowdown in global oil demand. OECD oil demand peaked in 2005, and Asian demand growth is weakening.

Saudi Arabia has for many years been the swing producer that adjusted its production to stabilise prices. During the 2008 financial crisis, OPEC agreed to deep production cuts to balance the market and reverse price drops. This time, the organisation was more divided. With US production growing faster than global oil demand, and as other OPEC members such as Iraq and Iran look to increase their output, the Saudis are no longer willing to carry the burden of cuts. In the November meeting, OPEC decided to maintain its 30 mbd production ceiling. After the decision was announced, oil prices fell sharply.

It is estimated that at least 1.5 mbd will have to be removed from the market in the first quarter in order to stabilise prices. OPEC is hoping lower prices will drive some high-cost non-OPEC production (particularly light, tight US oil) out of the market, but the big question is at what level US tight oil producers will suffer – and how long the low price pain will have to be endured. The estimated price needs of US producers vary widely, and it will take several months for production to react to lower prices.

The inability of the market to match rising supplies with weak demand raises the chance of further price declines. Oil prices of around $60 are predicted in the first half of next year, and the real pessimists are talking about $35 a barrel which would come when the world runs out of oil storage capacity. Some analysts are already warning of low prices for the next two years.

There are, however, several factors that could tighten the market and contribute to the recovery of oil prices. How the industry will react to the price downturn is yet to be seen. In a cyclical industry characterised by high capital costs, long investment horizons and geopolitical issues, a lack of investment may soon turn into a supply deficit. Repercussions from the oil price decline are already spreading beyond the energy sector, hitting energy company shares, currencies and national budgets.

US shale costs are higher than for many other conventional crude oil producers, and capital spending can be stepped up and down relatively quickly. Production has a steep decline rate, and constant drilling of new wells is needed to maintain production levels. Drilling is cash intensive. It has been indicated that drilling permits for new wells in US shale dropped by 15% in November, slowing the production growth rate.

Banks are also being affected, facing potential losses on energy-related loans. Some are saying that at least a third of the companies drilling for shale oil are in serious trouble. For drillers in some states, wellhead oil prices are already around $50/bbl because of the costs of moving this oil to refineries.

In addition to US shale, the oil price drop puts other high cost production such as Canadian oil sands, the Arctic and Brazil and Mexico’s deepwater production under pressure.

Capital expenditure plans are being curtailed, which may turn production too low. BP announced that it will intensify job cuts in response to the oil price drop. ConocoPhillips is cutting its capital spending plans by 20% next year, slowing its activity in US shale oil and gas exploration. Other companies are expected to follow.

The price slide is having a serious impact on oil producers that rely on oil revenues to balance their budgets. Currencies of oil producers like Russia and Nigeria are approaching record lows against the dollar. A depreciating currency will make imports more expensive, driving up inflation and increasing costs of dollar-denominated debt. Most OPEC producers rely heavily on oil income to fund their budgets. Failure to meet social welfare demands may cause instability.

The oil price fall should support oil demand by bringing a significant boost to the overall economy for oil importers. Transport and commodity costs are falling and the fuel bill of households is cut, boosting consumers’ spending power. China is taking advantage of lower prices, increasing its strategic stockpiling.

The effect of these developments could be a tightening of the market balance as early as next year, reversing the downturn in prices. It remains to be seen at what price level the new equilibrium will be found.
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