When OPEC leaders convene in Vienna tomorrow, the recent sharp decline in the oil price will top the agenda. Yet despite the pressures, our research suggests that the underlying economics of production should eventually drive the oil price higher from current levels.
Since the end of August, the price of Brent crude has fallen by more than 20% to about US$80 a barrel. It comes after three relatively stable years during which the price stayed within the US$90–110 per barrel range.
Several factors have triggered the decline. Demand growth has slowed, particularly in emerging markets and the euro area. Non-OPEC production growth has stayed strong, driven by the US shale revolution. And OPEC production has also increased as Libyan facilities have started coming back online. Meanwhile, there’s growing concern that Saudi Arabia is rethinking its commitment to play a balancing role in world markets.
Oil Price = Production Cost + Security Premium
But what really drives the oil price? In our view, oil prices are underpinned by the full cost of new production plus a security premium. This premium is influenced by the availability of spare capacity to meet potential supply disruptions (like the recent civil war in Libya or sanctions on Iran).
Oil demand grows slowly by about 1%–1.5% a year. That may not sound like a lot, but meeting this demand growth for about 0.9 million to 1.2 million barrels per day (bbl/d) is no easy task. Unlike most commodities, oil needs intense investment just to keep production flat, because producing fields decline by about 6% a year (or 5.5 million bbl/d). So the world needs new projects to deliver about 6.5–7 million bbl/d of new supply—just to preserve current spare capacity (Display).
Additional supply from US shale will help meet some of that demand growth. But we believe new investments in ultra-deep water and oil sands are still needed. According to our analysis, some of these projects require oil prices of at least US$80–90 to be economical.
Gauging Spare Capacity
Spare capacity matters for these calculations. Saudi Arabia controls most of the industry’s spare capacity, which amounts to about three million bbl/d, according to our estimates. That’s not really a lot considering that troubles in a major producer such as Libya, Iran, Iraq, Nigeria or Venezuela could curtail supply by more than one million bbl/d.
It also feeds into the security premium. Consumers are anxious to sustain smooth oil supplies no matter what, and will tend to pay to secure it when capacity is tight—or when there’s a perceived threat to supply. This explains why the oil price spiked in June as ISIS drove on Baghdad. On average we believe the security premium adds about US$10 to prices.
Taken together, all of these factors suggest an equilibrium oil price of US$90–100, according to our analysis. Of course in the short term, if production rises faster than demand, a glut of oil can push prices below this range. But if low prices persist, investment will be suppressed and spare capacity will tighten (Display). Then, prices are likely to begin rising again.
The Saudi Question
Short-term swings in demand and the phasing of new supply additions can cause the price to fluctuate. But in recent years, Saudi Arabia has adjusted production to keep the market balanced and prices fairly stable.
Saudi officials recently suggested that they might no longer be willing to cut supply to balance weaker demand and US supply growth. This may be a negotiating stance ahead of the big OPEC meeting on November 27—or it could reflect a desire to reduce investment by non-OPEC producers.
If OPEC moves to curtail production in the coming months, Brent prices could rise back into the US$90 range fairly quickly. Alternatively, a Saudi tactical shift could keep prices lower for longer.
But not forever. If US$80 oil is sustained for a year or more, we think the impact on investment will be significant and the seeds of a future spike in oil prices will have been sown. In our view, it’s only a matter of time before the market begins to recognize this—and starts to push up oil prices again.
© Alliance Bernstein