What Happened to Oil?
Since peaking at $107/barrel in June 2014, oil, as measured by West Texas Intermediate (WTI), has fallen -53% through Friday, February 20th to $50.81. At its lowest point on January 28th, oil had dropped -58% reaching $44.45/per barrel. The decline in prices has raised many questions. What caused the decline? What are the benefits and drawbacks to lower energy prices? Where do oil prices go from here?
Let’s take a moment to briefly explore each question.
What caused the decline?
Several factors are responsible for the decline in oil prices, including a stronger dollar and slowing global demand. However, the most important factor has been the growth in supply, driven primarily by U.S. producers, but also by Iraq, Canada and several other countries.
U.S. oil production peaked in 1970 at just over 10million barrels/day(mbd), satisfying 68% of total U.S. demand (14.7mbd). Over the course of nearly the next 40 years, U.S. production declined by 60%, falling to just under 4mbd in 2008, or 20% of U.S. demand, as supply from mature oil fields dwindled. However, the advent of horizontal drilling coupled with hydraulic fracturing revolutionized the energy landscape. In just six short years, U.S. oil production has rebounded by 125% to 9mbd, satisfying just under half of daily U.S. demand (19mbd). In addition to the U.S., other countries such as Iraq and Canada have steadily increased their production over the same time as well.
Of late, compounding the rapid increase in U.S. production has been the shifting role of the Organization of the Petroleum Exporting Countries (OPEC). For years OPEC functioned as the “swing producer” in the oil market, increasing or decreasing supply in order to balance markets and maintain relative price stability. As oil prices began to decline in the second half of 2014, many expected OPEC to intervene. In the past, OPEC would respond by cutting its supply to “defend” a certain price, be it $70, $80, $90, or any other price they felt was sufficient to encourage demand while providing an adequate return on investment. However, at their November 2014 meeting, OPEC (effectively Saudi Arabia) surprised markets by choosing to maintain production, thereby defending their market share, rather than defend a specific price. In doing so, OPEC effectively abdicated its role as swing producer with the hope that the resulting fall in prices would curtail U.S. production growth.
In addition to increasing supply, slowing demand has also played a role in oil’s recent plunge. Just as U.S. production was reaching levels last experienced in the 1970s, economists were busy revising downward their global economic growth forecasts. In June 2014, the International Energy Agency (IEA) forecasted global demand for oil to be 92.8mbd, up 1.8% from 2013. However, as concerns about slowing global growth intensified during the second half of 2014, the IEA revised downward its forecast. By December, they forecasted 2014 demand to be 92.4mbd, up just 0.6% from 2013.
Exacerbating supply and demand issues has been the rise of the U.S. dollar, which increased by ~13% in 2014. As with most commodities, oil is largely priced in dollars. As a result, the sharp rise in the dollar versus most other major currencies effectively made the cost of oil more expensive, thereby further reducing demand.
What are the benefits and drawbacks to lower energy prices?
For producers, the decline in oil prices has been painful. The second half of 2014, and in particular the fourth quarter, witnessed numerous exploration and production (E&P) companies announcing significant reductions in 2015 drilling plans along with headcount reductions. The pain has also been felt by a number of OPEC and non-OPEC countries whose governments rely heavily on oil revenues to balance their budgets and fund social programs.
Despite the impact on producers, economists generally agree that there is a net benefit to lower energy prices. At a macro level, UBS forecasts that for every $10 decline in oil prices, U.S. GDP growth should benefit by 0.1%. For the global economy, the International Monetary Fund forecasts that lower oil prices will benefit 2015 economic growth by 0.3% to 0.7% depending on the assumptions used.
For individual consumers, the benefit of falling oil prices is most easily observed in lower gasoline prices. Assuming the average household purchases 1,200 gallons of gasoline per year, if 2015 prices average $2.73/ gallon as they did in the 4Q14, as opposed to $3.45 in 3Q14, that would result in an annual savings of ~$870 per household. Corporate consumers have also benefited from the decline in oil prices. This is especially true for companies in energy-intensive sectors of the economy including industrials, manufacturing, chemicals, and transportation where oil, gasoline, and other refined hydrocarbon products represent a significant input cost.
One indicator that has received extra attention and generated differing viewpoints is inflation. As energy prices have dropped, there has been a corresponding decline in inflation readings, which has led to talk about disinflation in some corners. However, most economists agree that despite the lower inflation readings, the drop in energy prices is actually stimulative, increasing discretionary incomes that consumers can spend on other goods and services.
Where do oil prices go from here?
The short answer is that no one really knows whether the next $10 move in oil will be up or down. In an attempt to answer the question, analysts are closely watching a number of indicators including the Baker Hughes rig count, U.S. and OPEC production data, inventory levels, announcements by U.S. producers regarding 2015 drilling plans, and geopolitical events in the Middle East that could potentially impact supply. With so many variables to consider, it’s no wonder there are so many divergent views.
Citi Bank recently forecasted that prices could drop to as low as $20/barrel and remain in the $20 range for “a while” until excess production is removed from the market. Goldman Sachs recently lowered its 2015 and 2016 forecasts from $74 and $80 to $47 and $65, respectively.
Conversely, OPEC’s Secretary-General has opined that oil prices could eventually reach $200 due to under investment resulting from E&P companies’ current plans to significantly reduce future spending. It should be noted, however, that he did not actually give a timeframe for such an increase.
One indicator that has received outsized attention of late is the Baker Hughes rig count. Compiled by oilfield services company Baker Hughes, the weekly report details the number of drilling rigs operating in both the U.S. and international markets.
Conventional wisdom is that as the rig count drops, so too will production. Since peaking at 1,609 in mid-October, the U.S. oil rig count has declined by 550 rigs through February 13th. However, production has continued to increase. One explanation is that while shale producers are drilling less, they are focusing on their most productive acreage. In addition, continued improvements in fracking technology have increased the amount of recoverable oil from a given well.
The Bakken region of North Dakota is a good illustration of the recent divergence between a reduced rig count and production. According to the Department of Energy (DOE), as the number of rigs in the region declined -17% from a peak of 194 in September 2014 to 161 in January 2015, oil production per rig actually increased 8.9% over the same time. Currently the Dept. of Energy expects Bakken output to reach a record of 1.3mbd in March.
While U.S. production continues to increase for the time being, recent announcements by various E&P companies suggests that production will eventually begin to fall as capital spending plans are significantly reduced. According to Barclays, as a group, U.S. large cap E&P companies are expected to reduce their 2015 capital spending budgets by nearly $40B or one-third compared to 2014.
For its part, Saudi Arabia has been adamant in its refusal to cut production despite the drop in prices. In December, the Saudi Oil Minister shared his thoughts on the topic stating, “It is not in the interest of OPEC producers to cut their production, whatever the price is. Whether it goes down to $20, $40, $50, $60, it is irrelevant.” One could make the argument that OPEC will maintain its current production or even increase it, until such time that it believes enough marginal supply has been forced from the market that it can begin to let prices recover.
The precipitous decline in oil prices experienced in the second half of 2014 was due to a confluence of factors including rapid growth in U.S. production and OPEC’s refusal to reduce their own production. Though energy companies and governments that rely heavily on petroleum exports for revenue have been significantly impacted, the consensus view is that lower energy prices are a net positive from an economic standpoint, increasing discretionary income that consumers can spend on other goods and services. A falling U.S. rig count and significant cuts to E&P companies’ operating budgets should ultimately result in reduced U.S. production, despite the fact that has yet to occur. While the consensus expectation is that oil prices will end the year higher than the current level of ~$50, the wide range of opinions and OPEC’s refusal to reduce production suggests that oil markets will likely continue to experience volatility until such time that market dynamics exert enough pressure on supply and demand to bring the oil market back into balance.
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