Oil prices are influenced primarily by expectations of traders and investors buying and selling paper barrels. Over a sufficient period of time, prices arrived at on the paper market must take into account the physical balance of demand and supply, but at any moment in time the prices of physical barrels are more reflective of “sentiment” on the paper market than of physical availability.
It is quite remarkable how “sticky” the expectations of the paper market are. Certain narratives, or scenarios, come to be accepted as the consensus of the market although a little critical analysis would easily demonstrate that they are contradictory and untenable. This is partly due to the fact that on this market – as on most financial markets – money is made primarily by correctly anticipating the direction in which the market will move in the near future. This means that a specific narrative or scenario may well be irrational or unfounded, but as long as a majority of players believe in it, it remains the key to profitable trading.
We may ask why the market supported prices in the 100 to 120 dollars per barrel range for so long, creating conditions for the precipitous collapse of the last semester of 2014. The answer can only be that sentiment was influenced by several factually unfounded or logically contradictory expectations. Thus, to give a first example, there was the fear that political and military turmoil in the Middle East and North Africa would seriously affect the availability of oil and create scarcity conditions. In reality, there was little ground to support this expectation, because past experience has demonstrated that oil production and logistics are very resilient to conflict situations. The only serious loss in production was in Libya, and it was compensated by increases elsewhere in the world.
A further example concerns the impact of the increase in shale oil production in the United States. This was nothing short of phenomenal, adding upward of 3 million barrels per day to global production in three years, and growing exponentially. In fact, for several years the International Energy Agency has been updating a slide that clearly shows that the cost of production of practically all known and unknown oil resources is below 100 dollars per barrel.
The above is not properly a supply curve, because for most of these resources the investment required to bring the oil to market has not been sunk yet. That said, logic would tells us that if all these projects promise to be profitable, they will be undertaken at an accelerating pace – until the extent of supply will cause prices to decline and investment to slow down. US shale oil “revolution” is simply the one component of the total supply that has reacted more promptly to the attraction of extremely high prices – but a lot more is ready to follow. This means that prices above 100 dollars per barrel are unlikely to be tenable, because supply will eventually outstrip demand.
So, that is exactly what has happened. Ever since 2011 supply has exceeded demand, but prices remained high.
The last fallacy that the market believed in was that in any case if prices ever weakened OPEC (or specifically Saudi Arabia) would cut production in order to support them. The rationale for this was found in the so-called “fiscal break-even prices” – meaning the prices needed for specific countries to balance their budget. It was assumed that if prices were to fall below the fiscal break-even, OPEC countries would react by cutting production. This was a curious theory indeed, because it assumed that the more producers spent, the more prices would be pushed upwards – which is clear nonsense. It is spending that needs to adjust to the level of prices, not prices that will adjust to the level of spending.
So everybody was surprised when Saudi Arabia decided that cutting production would be futile in current market conditions, and prices above 100 dollars simply are indefensible. So surprised that most commentators and operators seem to believe that prices will soon bounce back, and are anxiously asking whether they bottomed out and how soon they will recover.
But what if prices will not recover soon? There are multiple reasons to expect exactly that: there is a lot of potential supply from various countries that is currently not available to the market for a variety of political or other reasons, but will come to the market in the coming months and years. Investment projects that are not yet completed but too far advanced to be called off will start producing even if they cannot fully recover the investment costs. Besides, there is plenty of oil that still is profitable even at prices hovering around 50 dollars per barrel.
In fact, when we look back to oil price history we can clearly see that the industry tends to have a 15-year price cycle: we had a high prices cycle between 1970 and 1985; a low prices cycle between 1986 and 2000; a high prices cycle between 2000 and 2015. This is clearly shown in the chart below, showing oil prices in dollars of 2013, and the average prices for the three 15-year periods. So I would not be surprised if we entered into a new low prices cycle to last until about 2030.
An extended period of lower prices would trigger very significant changes in the structure of the industry – and certainly also challenge the belief that we need to diversify away from oil because it is scarce and bound to be more and more expensive. We may not like oil because of emissions and climate change, but it will remain competitive, whether we like it or not.