EDITOR: | January 2nd, 2016 | 6 Comments

Why the world of oil is changing…

The supply and demand trend for the global oil market
| January 02, 2016 | 6 Comments
image_pdfimage_print

The only constant is change. We have known this for at least 2500 years since Heraclitus of Ephesus was first credited with this observation.

If you have any connection with the oil industry you may have a wry smile as you read this.

Part of my work is designing and delivering planning events for teams of senior management in some of the biggest oil and gas organisations. I help groups of people have structured conversations to share information then capture actionable plans. To give you an idea of the scale, these projects can range from $100million to $1000million.

Over the past year these big projects have been getting scarcer as the oil price has declined. Setting modesty aside, I’m good at this work and have kept busy designing and delivering strategic planning events in other industries.

I keep in regular contact with oil people in Europe, North America and the Middle East and they are all saying similar things – no one is expecting the oil industry to pick up for another year at least.

Is something fundamental changing in the oil world?

Time to take a look at this global industry and see what is happening. Before 2014 the price of oil had been steadily increasing for a decade. Since then the price of oil has been falling and at the time of writing is around $37 per barrel – an 11 year low.

When asking why the price is so low the first thing you will be told is that this is all down to basic economics, that there is too much oil chasing to few customers. This is true. You can see from the chart; supply has been exceeding demand consistently since 2014.

The supply and demand trend for the global oil market

The supply and demand trend for the global oil market

Adding the oil price trend shows that the low price coincides with the oversupply in the global market.

Supply Demand and Price for the global oil market

The supply and demand trend for the global oil market with the oil price

You will notice, dear InvestorIntel reader that this data also shows the oversupply narrowing but continuing into 2016. This means that the oil price will remain low for the coming year. The Energy Information Administration (EIA) broadly agrees with my contacts around the world. Expect no upturn in the oil industry fortunes for at least a year – unless something unexpected happens.

So, basic economics explains everything. Too much oil is being produced and the price has dropped. We could end this column at this point, but as you’ll know by now my curiosity drives me on…

Why should oil keep being produced in excess of demand?

In a rational market the oil suppliers should reduce production to meet the lower demand levels and the market would restore the price of oil to a higher level. Perhaps things are not quite that simple.

Let’s look at the big producers and consumers in the world.

The driving force behind the policy of sustained high levels of production is OPEC; the Organisation of Petroleum Exporting Countries that currently has 13 members

The biggest consumers of oil are China and the USA

Top ten oil consuming countries 2015

The largest customers for oil in the world

As the most significant consumer of oil, anything that happens in the US is worth paying attention to. The US is a producer of its own oil, however production peaked in the 1970s and since then is has had to import the extra oil needed to fuel the engine of economic growth.

In 2008 something interesting started to happen to oil production in the US as can be seen from this trend plot.

trend plot showing US oil production and the increase caused by fracking since 2008

The effect of the fracking boom on US production of oil

The impact of the hydraulic fracturing of shale oil (fracking) revolution can be seen in this plot. Since 2008 production of oil has nearly doubled. The US is well on its way to oil production independence

From the point of view of the major suppliers (OPEC) this is rather alarming. Your major customer is now on track to have its own independent supply of your product. There is further alarm. China, your second largest market has slowed its rate of growth.

As a set of suppliers OPEC had some tricky pricing decisions to make. Pricing cannot be controlled directly but is influenced by the amount of oil produced. Restrict the supply and the price will rise, and vice versa. There are three basic strategies:

  • Raise the price
  • Keep the price constant
  • Lower the price

Oil is an interesting economic good. Customers buy oil and use it to generate economic growth. This means they create more wealth that can be used to buy more oil. High oil prices generally reduce economic growth and oil price increases have preceded 10 of the past 11 US recessions. 

So, raising the price of oil in the short term is probably not a good idea. It will damage customers’ economies reducing the size of the market. Keeping the price of oil constant might not do immediate harm but it could prolong a depressed market. Doing nothing is not a good option.

What about reducing the price of oil? There are positive and negative effects. Falling oil prices can stimulate economic growth by lowering inflation. However in an already low inflation environment this can trigger deflation. Falling prices can lead to consumers delaying purchases in the hope of a better bargain tomorrow and this can lead to recessionary effects.

Another certain effect is that the economics of oil exploration and extraction are altered and high cost producers can be driven from the market.

This last effect probably explains much of the thinking behind the OPEC strategic policy and why we have had a sustained low oil price. OPEC members are mainly low cost producers and the shale oil frackers are higher cost producers.

Using a low cost production advantage is a great competitive strategy. However there are unintended consequences when the competition responds.

Spencer Dale, the group chief economist of BP recently wrote a persuasive paper on the new economics of oil  The low oil price environment is certainly hurting the expensive end of the production scale. Much of the exploration of extreme locations in the frozen north has ended and oil production from tar sands is increasingly under pressure.

Shale oil (fracking) production has not been hit as dramatically as expected. This is attributed to the different nature of the fracking production process. Horizontal drilling and hydraulic fracturing is a repeatable process unlike conventional production that relies on massive capital investment and long-term payback times. Repeatable fracking processes (refracking) are smaller individual projects and can be managed as standardised industrial processes that have a learning curve or experience curve. This means that the more often a process is repeated the lower its unit costs become. This is why the US fracking revolution is inherently more resilient than its competitors would have anticipated.

 So what does this all mean for the new world of oil?

Oil has been produced in excess of demand to lower the price in the hope that the global market can be nurtured by:

  • Putting pressure on higher cost competitor producers
  • Stimulating the economies of consumer countries

The low oil price will probably be maintained for the foreseeable future to keep the pressure on shale oil competitor producers in North America.

More supply capacity is coming into the market from a post sanctions Iran and this will create further downward pressure on oil prices. This will probably strain relationships within OPEC.

The shale oil producers will be under pressure to prove they can keep reducing their costs through efficiency gains.

With sustained low oil prices there will be a continued cost reduction focus on the industry as a whole. This means careful operations management balanced with good safety leadership will be a critical survival factor.

Expect smaller, flexible oil production operations that come and go and fewer new large-scale capital intensive projects by private oil companies. Large projects will become the preserve of national oil and gas organisations that can take a longer-term view driven more by politics than shareholders and economics.

This assumes all other things being equal. These finely tuned markets can be thrown into disarray if there are geopolitical disturbances in major producer or consumer countries. Our planet could affect everyone’s calculations too if we get extreme weather events or geological disturbances.

It is worth remembering that 2500-year-old observation that the only constant is change – and keep that wry smile.


Editor:

Adrian Nixon is a Senior Editor at InvestorIntel. He began his career as a scientist and is a Chartered Chemist and Member of the Royal ... <Read more about Adrian Nixon>


Copyright © 2017 InvestorIntel Corp. All rights reserved. More & Disclaimer »


Comments

  • Jeff Thompson

    The second chart tells a key story. Look at the scale of the primary y-axis, notice it doesn’t have a zero-crossing – it doesn’t need to. The entire supply/demand balance is range-bound between 85 to 97 (million barrels per day). But the secondary y-axis has a significantly higher dynamic range from 30 to 150 (USD per barrel). On the x-axis, from 2010 to mid 2014, there are multiple green line/red line crossings indicating supply/demand equilibrium and a somewhat stable oil price averaging around $90 a barrel. From mid 2014 to end of 2015, there is oversupply in the market and price of oil is reduced by 50%.

    But the key is look at the amount of oversupply that produced a 50% drop in price. Through late 2014 and 2015 the oversupply ran at about 2 million barrels per day out of baseline of about 90 million barrels a day. In other words, a roughly 2% oversupply led to a 50% price reduction. That’s a 25:1 sensitivity ratio. It didn’t take a 50% oversupply, or 135 million barrels a day production, to cause a 50% price reduction. 2% alone was enough to do it. Mathematically, the price of the commodity is essentially the derivative of the differential between supply/demand, with a large negative coefficient in front of it.
    I would expect similarly high sensitivity if and when oil supply ever falls even slightly below demand. Once demand falls 1% below supply, expect to see the price of oil overreact to the upside and shoot right up. It’s like you were driving down the highway at 90 miles per hour (not recommended), then just slightly applied a tap more pressure to the accelerator and raised your speed to 92 miles per hour (2% increase from equilibrium), and suddenly the S&P 500 fell 50% in value, and then you adjusted the pressure on your foot again and trimmed your speed ever so slightly to 88 miles per hour (2% decrease from equilibrium), and suddenly the S&P 500 rose 50%. That sort of sensitivity sounds crazy, but it is real, and it is only going to take a few of the giant oil conglomerates to tap on the supply breaks lightly to restore that balance.
    And this is occurring in the extremely liquid (literally) oil market, which is orders of magnitude larger than the far less liquid rare earths market. This same commodity pricing dynamic in relation to small imbalances in supply/demand equilibrium is currently playing out in parallel in rare earths, where the oversupply is much larger than 2%, as pointed out elsewhere, and prices have fallen significantly more than 50%, often in the range of 70%-90%, to the point where we almost need to switch to a log scale instead of a linear one as numbers converge towards zero. It will be interesting to watch the oil and rare earths markets in the next 1-3 years, as it will only take the small actions of a few of the larger players (either private companies or nation state actors) in either commodity to cause significant price movements.

    January 2, 2016 - 5:21 PM

  • Timothy Ainsworth

    Jeff, RE market needs to be separated LRE/HRE, two very different dynamics at work.
    Not meaning to distract from your broader commentary, but the distinction worth making IMO.

    January 2, 2016 - 6:02 PM

  • Jeff Thompson

    Tim,

    Definitely agree. Unlike the oil market where the price spreads between WTI, North Sea Brent, and Dubai crude are relatively small in percentage terms, rare earths are more nuanced with much larger differences in price depending on which of the 17 elements, or as you point out, between lights and heavies when grouped that way for convenience. With some of the most important lights in modest oversupply at the moment, and some heavies in large oversupply and a clouded demand picture, price drops in recent years reflect that.

    I thought Adrian’s article on oil, and particularly the second plot, highlighted an important principle that small undershoots or overshoots in supply relative to demand produce dramatic movements in price in many commodity markets, with each individual commodity having its own signature sensitivity ratio.

    OPEC may have miscalculated in an attempt to keep market share, as I believe in the long-run their November 2014 decision to keep supplies high may be viewed in retrospect as an accelerant in the worldwide attempt to find more efficient extraction techniques, which had already begun prior to their decision.

    Regards,
    Jeff

    January 2, 2016 - 7:49 PM

  • hackenzac

    Jeff,
    Your algorithm for observing high price volatility versus relatively small changes in supply versus demand doesn’t take into account the magnifying effect that derivatives trading might be having similar to the way that derivatives strongly compounded the real estate collapse. There’s probably something more going on than a simple supply/demand dynamic. Since there’s not much of a futures market in rare earths, they would be more subject to the basic law than something like oil subject to the compounding effect of futures trading. My understanding of the real estate collapse was mostly caused by derivatives contracts on a bubble and it follows that maybe we’re seeing something similar in oil.

    January 4, 2016 - 11:30 AM

  • Jeff Thompson

    True, derivatives could accelerate price changes in the larger markets like oil, whereas in smaller markets like rare earths there might be a similar effect from the lack of liquidity.

    January 4, 2016 - 3:37 PM

  • Prepare for, rather than predict, future events in the world of oil… | InvestorIntel

    […] few days ago I wrote a column summarising the reasons for the sustained low oil price. The day after, Saudi Arabia and Iran […]

    January 7, 2016 - 1:44 PM

Leave a Reply

Your email address will not be published. Required fields are marked *