In the past few weeks I have received numerous questions about the role of a “drop in demand” in the oil price decline. These questions are driven by many stories in the media that have referenced a drop in demand.
There are two primary reasons given for this so-called demand drop. One is that years of high oil prices have resulted in reductions in consumption through conservation and improvements in vehicle fleet efficiency. The second reason is due to the strengthening dollar, oil has become more expensive for many countries since oil is generally traded in dollars.
There are elements of truth behind both reasons. There has indeed been reduced oil consumption in recent years in most developed regions of the world. It is also true that the dollar has strengthened against many currencies. But despite the rationale that explains this drop in oil consumption, ultimately the data must support the narrative.
We have to keep in mind that the developed regions of the world aren’t the entire world. Despite this oft-repeated mantra about falling oil demand, there is no evidence that this is actually true. Last October, the International Energy Agency (IEA) reduced its forecast for 2014 global oil demand growth by 200,000 barrels per day (bpd). Their revised forecast was that global oil demand would only increase by 700,000 bpd from 2013. Related: Oil Price Collapse Hurting Some More Than Others
Last week on CNBC the IEA forecast that “global growth in the demand for oil could modestly accelerate in 2015 to 910,000 barrels a day.” However, the article also noted that the World Bank had reduced their forecast for growth in the global economy for this year to 3%, down from their previous forecast of 3.4%.
What has happened is that these reductions in the forecast for oil demand growth or economic growth get mistranslated into forecasts of declining demand. I think we can all agree that if I gained 5 pounds a year each year for the past 5 years, but this year I only project that I will gain 3 pounds — I did not lose weight. I will be 3 pounds heavier than I was instead of 5 pounds heavier.
Consider that in the 5-year period of 2008-2013, the price of West Texas Intermediate (WTI) crude averaged $88/bbl. The price of Brent crude was even higher at $95/bbl over this period. These prices were much higher than the average oil price over the previous 5-year period, therefore we might expect that this had a negative impact on oil demand. This was in fact the case in the U.S. and E.U., but global demand increased, driven by increases in every developing region of the world:
Despite much higher oil prices, global demand for oil increased by more than 5 million bpd in the past 5 years. In fact, global oil consumption has increased in 18 of the past 20 years. Related: Iranian Oil Industry Not Threatened By $25 Oil Claims Minister
Now, compare that with where most of the world’s oil production growth took place during that time period:
This is why I maintain that oil below $50/bbl is simply not sustainable. If global demand was actually declining, it would be a different story. But with demand continuing to grow, and with the majority of the oil production added in the past 5 years coming from the shale oil fields in the U.S., there is simply not enough $50/bbl to meet demand. Consider the graphic from a Bloomberg story late last year that shows almost every shale play in the U.S. losing money at current oil prices:
Now consider that companies in these shale plays are reducing their 2015 budgets, and layoffs are underway. The cure for low oil prices is low oil prices, and that cure will begin to take effect this year. I realize that we dropped into the $30′s in 2008, but keep two things in mind. Just over a year later we were back above $100/bbl, and at that time the marginal barrel was not $70/bbl shale oil. The cost to produce that last million barrels per day of demand is significantly higher than it was in 2008. Therefore oil will not — as I have seen more and more pundits predict — sink to $40/bbl and stay there. There may be a new norm for oil relative to what we have seen in the past 5 years, but it will be closer to $70/bbl than it will be to $40/bbl.
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By Robert Rapier
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Another factor is tight oil capital costs. Half the costs are upfront. They're a sunk cost. That means the wells only cost half as much as they did before they were drilled. Which means their production cost is not $70 but whatever operating costs are. Original investors take it on the chin due to their original capital cost, but the oil still flows at $50/barrel or less.
Finally, Saudi Arabia and Iran are at odds. They both want to dominate Islam. Iran is strapped due to Western sanctions. If the US and Iran work a deal (much more likely now that we have proven energy security) they will pump to finance their political endeavors. Saudi Arabia will do the same.
Consequently, mid to sub $50 seems sustainable. Maybe for five years or more. By the time demand overcomes OPEC's maximum production we will be building coal to oil and natural gas to oil production facilities at $60/barrel or less. Unless tight oil gets so good that we never need syngas facilities.
Consider, that without North America, which is mostly shale, the frenzied panic causing 1 mmbo/d "glut" would be a 2 mmbo/d deficit. What would the price be then?
Consider that 2 mmbo/d from the ME is a rabbit from the hat that can't easily be repeated and for which at least 1 mmbo/d is geopolitically fragile.
Consider that for every shale rig having reached plateau production rate that the production rate from the string of wells drilled by that rig will have dropped by almost 50% within a year's time. Only 50% of the rigs have to go down for a 750 to 800 mbo/d reduction in shale production in 12 months... perhaps sooner. 50% of the rigs standing is starting to look optimistic.
Consider that 90 mmbo/d of non-shale oil declines at something in excess of 2% a year without relentless drilling of new wells. Let's just say 2% decline or -1.8 mmbo/d.
Consider that almost all of the 1 mmbo/d glut will be consumed by the 900 mbo/d increase forecast by the EIA.
In the by-the-way column. Russia's current maximum production is simply not sustainable.
I humbly suggest that by the third quarter of this year we will not be frenzied by a glut but by a shortage of more than 1 mmbo/d.
This is all so foolish.
PS, the Saudi's can run for at least 5 years at this price so prices will not increase because the Saudis get concerned about that. Maybe about some other country getting really po'd at them over the price but not because they need the money.
I find a contra-argument more valid, that for the next 12 to 18 months (but for maintenance of refineries this spring), we will not see that rise. Saudi Arabia (their raw cost is one of the lowest worldwide out of the ground at $6.00/barrel) will not stop pumping oil at its capacity in its desire to keep Iran in a corner on its nuclear program funding. Sanctions and the lower prices are definitively keeping Iran's economy in shambles. Second the Emirates, like the Saudi's, want gain new market shares, knowing that as prices keep dropping the new oil supplies from tar sands and shale fracking is increasing America's self sufficiently. No doubt the Saudi's and Emirates are betting some of these operations may have to shut down if cost benefit ratios make it fracking unprofitable to continue.
With the tar sands and shale oil fracking creating more oil (despite higher cost to retrieve out of the ground), the supply has continued to increase. Despite China's previous growth and consumption, China is shifting economic policies from exports to developing internal markets due to the world slow down for China's exports and China's demand while still growing, its demand is slowing in its demand. Next the fall of Venezuela's economy and its foreign debt crisis (CNBC notes their foreign reserves are about six months) by the former Chavez and now Maduro's political motivations, Venezuela has misallocated its resources by funding Cuba, Bolivia, Nicaragua and other countries through discounted oil prices, creating accrued debt and in many instances uncollectable debt, again leaves them pumping a heavier oil, trying to hold on to market share and desperately trying to obtain more foreign currency to avoid a Nation bankruptcy. Were Venezuela to default (highly likely by 2016), the government would have to seek aid from International Institutions. Likely it would be the IMF which translates to the IMF providing assistance with the caveat of regime change through political reform, tax reform, land reform, etal. That type of international rescue would take anywhere from 18 to 24 months to see those reforms and change to that economy.
Finally we have Russia, who's reserve funds are dropping by the day (if their financial statements are accurate). Putin never diversified when oil was running at $110/barrel and now at $45+/barrel he is trying to divert the falling economy and shortages of goods to the general population by his incursions into Ukraine. The political sanctions and the falling oil prices have destroyed his Ruble and his ability to import necessary goods is crippled. He too is pumping as much as possible like Venezuela to obtain foreign currency.
Adding the Saudi's goals to keep Iran in the corner, Russia and Venezuela pumping as hard as they can and add that the largest developing country (China) slowing down (significantly by external numbers, not China's published numbers), I cannot as an International Economist concur to the premise that we will see any significant oil price rises in less than 12 to 18 months. Yes as cited above we'll see a small rise this spring 2015 due to refinery maintenance but oil prices will remain low due to geopolitical reasons which will continue to impact the increased supply continuing to exceed demand until well into mid 2016.
Ken Peters PhD
International Economist
Lynn University