Where Oil Prices Are Heading In 2015
According to the IEA, aggregate demand for oil is projected to be 93.3 million barrels per day in 2015. The simple reason that we’re enjoying much lower prices at the pump is because the global energy producers (including OPEC) are currently producing 94.1M barrels per day (as of Nov 2014).
So, assuming that rate of production continues, we’re supplying approximately 800,000 too many barrels of oil each day to the global marketplace.
So, we’ve now gotten into an over supply “glut” situation that must be corrected. Since OPEC decided to not answer the “call” to reduce production for fear of losing market share, the broader commodities markets reacted by driving the price of oil down in an effort to reduce supply. In theory (and for all practical purposes), the lower price will take oil supply off the market because producers will not want to sell it for less than they spent to produce it.
Now, when you think about this over-supply, you have to remember that demand is sort of a moving target, so you have to look at the various GDPs across the globe to determine whether or not the “glut” will be consumed by growing countries through increased demand. After the smart analysts looked across the globe for growth, they projected that there wouldn’t actually be any increased growth, or increased demand. In fact, demand may even be less than previously projected meaning we’re producing even more than we had previously suspected. This news drove the markets into a frenzy, driving oil prices down to 5 year lows. Today’s price (Jan 12, 2015) was a staggering $45.92/barrel. In fact, the analysts at Goldman Sachs are now projecting $40/barrel oil to get the price point where supply meets demand (or equilibrium.) There’s a lot of reasons for this. Some of it has to do with production vs. drilling costs. Since the drilling expense is already a “sunk” cost, companies are now looking at the day to day cost of production. Bringing the oil to market during post-drilling production is much cheaper than drilling new wells, so they look to those numbers for good profit margins. If they can’t at least meet production costs, they’ll just turn the pumps off until they can secure a good enough price to re-engage in production. $40 seems to be the point where companies can sell their existing oil production at a good enough margins to leave their pumps on, so that’s probably why Goldman set the target at that price point. As a side note, I disagree with Goldman’s assessment as I believe oil has already began coming out of the market place at current “spot” prices.
Oil As A Traded Commodity
Okay, now just some general words about oil… Oil is the most highly demanded commodity in the market. More than any other single thing. It’s also (probably) the most volatile commodity as well. This is why any sort of news that disrupts the supply chain, or increases demand is met with outlandishly high prices in the market. While no one can really predict oil price with any degree of accuracy, there are definitely several things that cause “buzz” in the oil market. Some of them include:
- Current Inventories
- Aggregate Production
- Aggregate Demand
- Regional Instability and Conflict
- GDPs (and growth forecasts) of the largest oil consumers
- Substitute products that don’t use oil, like electric and to some extent, hybrid vehicles
The above list represents a small sampling of what drives oil price, but rest assured, there are many other factors contributing to the up and down movements of oil.
The Effects of Hedging
Because oil prices are so unpredictable on the commodities markets, energy companies like BP, Shell, and Exxon Mobile hedge their production well into the future. This simply means that they buy contracts to sell their oil production at what they consider to be a reasonable price at some point in the future. In fact, many of these companies are now reaping the benefits of hedging selling the oil they produce at $90 or $100/barrel. This is one of the many reasons you haven’t seen them scale back on their output. They’re getting great prices off of contracts they bought several months earlier on the Futures Market. Now, any un-hedged production they deliver to the marketplace will be sold at prevailing “spot” prices which are only 50% of what they were several months ago or where they’re selling their hedged positions. The big question on everyone’s mind is whether or not they’re willing to sell at these depressed prices? I’d suggest to you that most of the bigger players will probably not engage in the sell of un-hedged oil. Some of the smaller companies may have to sell at the lower price point to meet their current liabilities, but they’re probably not real happy with it. In the aggregate, supply will immediately begin to shrink as producers expend their hedged positions. Like many are saying, this will take some time to work itself out…
OPEC Cuts Production
Amidst the OPEC rhetoric at the end of November 2014, we later discovered that OPEC cut its own production that same month by 315,000 barrels per day. Now, OPEC was historically producing above it’s stated goal of 30 million barrels a day, so they were actually over-producing the entire time helping to create the oil glut of 2014. The fact is, OPEC did in fact cut production while they were publically stating they weren’t going to. See below for my source.
As prices trended down, Russia was also seen cutting its exports, choosing instead to send its oil to its own refineries. In addition, inventories in the United States began trending down at the end of December and early January 2015.
If I were you, I’d ask for proof. In response to that, I’m providing you the following graphics that depict clearly the situation in November and December of 2014:
First, here’s the screen shot where I found the OPEC November 2014 production cut (Source: IEA.ORG):
Next, I’m going to show you where US inventories declined. From Dec 26, 2014 to Jan 2, 2015, crude oil stocks declined from 385.5 to 382.4 million barrels for a net decrease of 3.1 million barrels. Now, don’t get me wrong here, I don’t think this was a super incredible decline, but signaled to me that oil was coming out of the market. We’re certainly way up from this time last year level of 357.9 million barrels(Source: EIA.GOV):
In recent days, OPEC has publically stated that they will no longer be the world’s balancer to support a particular oil price. In fact, they’ve lost market share over the last several years that essentially explains why they’re taking that position. Here’s a chart that pretty much lays out the issue:
The above chart was produced by Bloomberg and essentially lays out OPEC’s problem. I really like the graphic because you can clearly see that the US, Canada, and Brazil have all increased production while OPEC has remained a steady producer and actually lost a significant share of the oil market.
Assuming we believe global oil demand is truly 93.3 million barrels a day and supply is truly 94.1 million barrels a day, we really need to digest this at the macro level. Look, if OPEC is producing 30 million barrels a day, then their effort is only meeting one third of the world’s demand. The other two thirds is coming from all the other countries around the globe who produce oil. From my little foxhole, I see that OPEC is already lowering to 30 million barrels per day. They’ve been over-producing their target the last several months by 3-400,000 barrels per day. They will not come off the 30 million, but won’t produce more than 30 million, particularly at these prices. The fact that they cut over 300,000 barrels a day has already solved a third of the global over supply.
I suspect that an oil price of $70-$80 a barrel probably took a number of players out of the market as we saw a drastic reduction in rig count even before OPEC announced they weren’t going to cut their production in Geneva. At $40-$50 a barrel, most shale drillers cannot be profitable and just won’t engage in new drilling activity. Because shale oil is so short-lived (one to two years of production), shale drillers will pack up their drilling toys and go to the house. That leaves the long-life production assets in play, but most producers will only sell enough of their production to get by in these trying times of low price points. At today’s prices, I suggest to you that the imbalance has already been corrected. In fact, we’re most likely under-producing on a global scale already!
Russian Oil Picture
Russian Energy Minister Aleksandr Novak publically stated in mid-December 2014 that Russia will most likely produce at the 2014 level, but not under take any new projects. He went on to state that exports would decrease as demand picked up within the Russian borders. His exact quote was:
“Russia does not increase the supply of oil in the world market … We plan to maintain the volume of production at the 2014 level. At the same time exports decreased due to growing domestic consumption.”
This is a fairly significant statement as it also takes excess production off the table.
Oil headed up in 2015
Before I give you my prediction for 2015 oil prices, let me preface some things. There are several key assumptions I’m making here. The biggest one being that most oil producing countries cannot sustain their economies on $40/barrel oil. Here’s some things I’ve considered in the estimate:
- OPEC will maintain their production at close to 30 million barrels (or less) per day. I’d expect for many of the member nations to announce shortages for a variety of far fetched reasons. Rest assured though, that it’s completely about price and not the rhetoric they’ll be spouting.
- Countries cannot sustain their economies on $40/barrel oil. Many need it to be above $90/barrel to balance their budgets. See the below graphic for more detail.
- We’re assuming stabilized demand of approximately 93 million barrels per day.
- Expectation of several “supply side” excuses for under-production. This could be anything from unrest in the producing countries to unavailability of transportation rigs who are currently being paid for storage instead of active transport of produced oil.
- Hedges will begin to run out and producers will begin to turn off production. I know this sounds far fetched, but if you knew you could get by and wait a few months for prices to rebound, wouldn’t you?
You need to understand the point I’m making about balanced budgets to really get all of this. Here’s where countries need oil prices to be to balance their budgets:
As you can see from the above chart, many countries need oil prices to be around $100/barrel to balance their budgets. Many of them are members of OPEC and don’t like low prices. They’re all counting on $100/barrel oil to pay their bills, so it stands to reason, they’ll do whatever they can to achieve their own interests. This is why I stated above that I’d expect to start seeing disruptions in the supply chain to increase the price point.
Yes, we’re over producing, but not by much! Certainly not enough to drive prices down to today’s price point of $40 to $45/barrel. Like I said, it’s going to take some time for this situation to work itself out, but rest assured it will. Based on everything I’ve told you in this article, my prediction for December 2015 oil price is in the $80-90 a barrel range. Looking out toward the middle of 2016, you can expect prices to climb back to well over $100/barrel.
There will be much turbulence and speculation along the way, but the market will find a way to bring prices back to justifiable levels. For now, just enjoy the cheap gas prices. I smile every time I fill up my gas guzzling truck because I’m saving a ton of money at the pump right now. Look, I really like cheap energy. It’s good for the economy. It’s good for me. Unfortunately, the reality is that it’s not here to stay. Even without OPEC intervention calls being answered, the laws of supply and demand will begin to take hold. Oil prices will head back up folks. It’s just going to take some time! At these prices, I’m currently long the oil play and certainly wouldn’t establish any short positions here. Over production just wasn’t as excessive as the data clearly indicates. Downward pricing is a clear over-reaction by speculators.
Disclaimer: These are my own personal views on oil prices, so please perform your own due diligence before making any investment decisions. The analysts are much smarter than me. This is just my take.