Half way through the year already and the nights are already drawing in! By any standards, the first 6 months of 2016 have been fairly remarkable in oil terms. “What’s that? Have you not noticed that the oil price has doubled in 6 short months?!” Maybe it’s because at $50 per barrel, the oil price still seems unremarkable versus the highs of the recent past. But imagine if house prices had doubled in the same period? Or cars? Or even a loaf of bread? Then the ire of the public would be well and truly provoked, and yet this latest surge in oil prices has barely elicited a murmur.
What is going on? Well to some extent what we have seen is a re-balancing of supply and demand and an oil market that (through its recovery) has acknowledged that the 2014-15 fall in the value of crude was probably overdone. Ignoring the usual clownish predictions from the banks ($10 a barrel anyone?), the fact is that $25 per barrel was probably too low a price to last for long. In the States – to a backdrop of OPEC cheers – the drillers did start to go bust at the beginning of the year and the production figures bear witness to this fact. From 2010 to 2015, US oil production rose from 6m barrels per day (bpd) to 9m bpd. But in the first half of this year, that figure has dropped to 8m, meaning a full 10%+ of US production has been taken off the market. At the same time, the massive supply disruptions in Nigeria are beginning to bite, with estimates of up to 500K bpd being stolen by Niger Delta rebels (that’s the equivalent of circa 60% of annual UK oil production in the North Sea).
To counter these major drops in oil supply, we have the rapid increase in oil production from Iran. Experts had estimated that it would take more than 12 months for Iran to get back up to its pre-sanction production levels of 4m bpd. But in fact it has taken less than 3 months and this has added a whopping 1.3m bpd onto the markets. If you take the extra 1.3m barrels from Iran and then net off the reductions from the USA (1m bpd) and Nigeria (0.5m bpd), then we have a minor supply / demand imbalance balance of -0.2m bpd. This figure in isolation would not be large enough to send oil prices rocketing upwards, particularly as the situation has to be viewed in the context of a market already glutted with oil. But hold on there, what about demand? When we factor in a consumption increase of 1m bpd (for the final time, demand for oil is increasing every year…) and now the maths looks decidedly different. Supply / demand is currently out of kilter to the tune of negative 1.2m bpd and this has easily been enough to push prices back up quickly since the beginning of the year.
So what can we expect for the rest of 2016 and into 2017? Well at the current juncture, a good metric is what Portland calls the “$25 – $50 – $75” rule and it’s pretty simple. At $25 per barrel, oil exploration becomes commercially unviable in most forms and production stops (with many producers going bust to boot). This takes product from the market and prices start to push up. At $50 a barrel, supply and demand start to balance out and if this status quo could be maintained, both producers and consumers would be satisfied (consumers more than producers of course!). But that’s not how markets work when worldwide demand for the product in question is constantly increasing. Pressure starts to build and prices continue to rise to the point where they are attractive enough for production to accelerate. The charge back into production will of course be led by the shale oilers, as these guys do not need long lead times to get cracking again. And don’t trouble yourself with the question of who will do the drilling, when so many shale oil operators have gone bust. Low prices may bankrupt a company, but they can never bankrupt a technology; the genie is out and when the price is right, the rigs will be dusted down and shale oil will return.
When that happens, we will experience another glut in supply and prices will be rapidly pushed downwards to the $25 mark, so that the cycle can begin all over again. Producers and consumers should expect significant volatility between a $25 and $75 range for the foreseeable future. The former would be foolish to hold out for the heady days of $100+ per barrel but equally, the latter should not expect prices to fall below $25 or even stay at that level for any prolonged period of time.