Will $50 be oil’s floor, or its ceil­ing?

Financial Mirror (Cyprus) - - FRONT PAGE -

The price of crude oil is set to re­main de­pressed at least through 2015, un­til the Saudis are sat­is­fied that they have in­jured their geopo­lit­i­cal and eco­nomic com­peti­tors se­verely enough to re­gain pric­ing power. The big ques­tion now is whether a price of around US$50 a bar­rel—some 10-15% be­low present lev­els—forms the floor of oil’s trad­ing range for the next few years, as it did be­tween 2005 to 2014, or whether US$50/bbl is es­tab­lished as the ceil­ing of a new lower range, of the sort that pre­vailed from 1986 to 2004.

There are sev­eral rea­sons to ex­pect the oil mar­ket to set­tle into the lower range. The most im­por­tant are the tech­no­log­i­cal and en­vi­ron­men­tal pres­sures that are re­duc­ing long term de­mand and threat­en­ing to turn much of the high cost oil re­serves out­side the Mid­dle East into ‘stranded as­sets’ sim­i­lar to the earth’s vast but un­wanted re­serves of coal. Ad­di­tional pres­sures for lower oil prices in the long term may in­clude the pos­si­ble lifting of sanc­tions on Iran and Rus­sia or greater sta­bil­ity in Iraq, which would even­tu­ally re­lease oil re­serves as big as Saudi Ara­bia’s onto the world mar­ket.

In the short term, pow­er­ful down­ward pres­sure is be­ing ex­erted by mar­ket po­si­tion­ing, which is still sur­pris­ingly bullish. In the week to De­cem­ber 9, spec­u­la­tors still held net long po­si­tions in the US fu­tures mar­kets of 261,000 con­tracts, a level higher than at the peaks of the bull mar­kets in 2008 and 2011-12. This sug­gests that the liq­ui­da­tion phase of the bear mar­ket has hardly even started. It seems that spec­u­la­tors are still fish­ing for a bot­tom rather than fol­low­ing the trend, as they nor­mally do.

The shale revo­lu­tion is another rea­son why the oil mar­ket may move away from the sort of mo­nop­oly pric­ing dom­i­nated by OPEC that was seen be­tween 2004 and 2014 and to­wards a more com­pet­i­tive regime. Shale oil pro­duc­tion, although rel­a­tively costly, can be turned on and off much more read­ily than con­ven­tional oil­fields, with their enor­mous ex­plo­ration and cap­i­tal costs. This means that in fu­ture the ‘swing pro­duc­ers’ who bring global oil sup­ply and de­mand into equi­lib­rium will be US shale prospec­tors, rather than Saudi of­fi­cials. If there is an eco­nomic ra­tio­nale be­hind the re­cent Saudi ac­tions it is to en­sure that low cost OPEC pro­duc­ers can pump at full ca­pac­ity, while shale pro­duc­ers cut pro­duc­tion when de­mand is weak and ramp it up when de­mand is strong. If this is how the oil mar­ket is go­ing to work in the fu­ture, then the mar­ginal cost of US shale pro­duc­tion will set the ceil­ing for global prices, not the floor.

On the other hand, there are some strong ar­gu­ments for the higher post-2005 trad­ing band to hold, once the bot­tom of this range is tested by a price of $50 or slightly lower. The most im­por­tant of th­ese bullish ar­gu­ments is that OPEC could pre­vent a re­turn to the 1986-2004 regime of com­pet­i­tive mar­ket pric­ing by learn­ing to func­tion again as an ef­fec­tive car­tel. All OPEC coun­tries ben­e­fit by curb­ing their out­put and push­ing up prices. Although such price fix­ing be­comes ever more dif­fi­cult as pro­duc­ers out­side the car­tel in­crease their mar­ket share, OPEC could make a se­ri­ous at­tempt to im­pose pric­ing ‘dis­ci­pline’ if enough US shale pro­duc­ers get knocked out in the next year. More­over, the macro- eco­nomic im­pact of low oil prices on global growth should be ex­tremely pos­i­tive. So late 2015 or 2016 could see a boom in global eco­nomic ac­tiv­ity, re­sult­ing in stronger oil de­mand.

So, which of th­ese ar­gu­ments will prove right-the bear­ish case for a US$25-50 trad­ing-range based on com­pet­i­tive oil pric­ing, or the bullish case for a US$50-100 range based on con­tin­u­ing OPEC dom­i­nance? No-one can pre­dict this with any con­fi­dence. Ask us again after the oil price has fallen to US$50 and stayed near that level for a year or so.

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