Market and Economic: Global Investment Forum

Oil: the end of ‘lower for longer’?

Night View on Oil refinery unit in the countryside

Any global economic view has to consider a prognosis for the oil price given its importance for the world economy and financial markets. The price of oil is driven by supply and demand dynamics, with geopolitical factors also playing a significant supporting role. In recent years, however, the pricing environment has been skewed by moves by the production cartel OPEC to protect its market share from the disruptive emergence of U.S. shale producers.

Looking at the supply side more closely, we note that after the last downturn in oil prices, the industry was capital starved, which limited output. This was reversed, as prices recovered and new technology enabled huge reserves of cheaply extracted U.S. shale oil to hit the market. OPEC responded by ramping up production in a bid to keep the oil price too low for shale production to be economically viable. Its lack of success in this endeavor suggested that the oil price would remain locked in a relatively low range for an extended period.

Expectations of plentiful supply keeping a lid on oil prices have been revised by skepticism about OPEC’s ability to control production in the way it once did as well as the long-term economic viability of shale. For shale, considerable reinvestment in wells is needed just to keep production flat, which is casting doubt on the sustainability of the process.

Given the uncertainty about supply growth, what about the demand side of the equation? With the global economy looking reasonably healthy, we would expect the demand for oil to be well supported. While increasing concerns about climate change are being reflected in the growing attention paid to renewable energy supplies and the sharp rise in the sales of electric vehicles, this is being negated by the overall growth of ownership of conventional cars, not to mention rising annual mileage, in emerging markets. Certainly, extraordinary advances in the fuel efficiency of new cars are helping to temper the rise in the global thirst for oil, but is this enough to dampen overall demand sufficiently to keep prices in check? The balance of probabilities suggests not, in our view.

Overall, it seems more likely that supply factors will dominate the outlook for oil prices, suggesting they will continue to trend higher in the short to medium term. Whether it’s ‘peak oil’ or ‘lower for longer’, the oil market has a habit of confounding expectations.
 

Oil Excess Demand / Supply Balance
Source: IEA, as of September 2018. Oil demand is total oil traded measured as deliveries from refineries and primary stocks, comprises inland deliveries, international marine bunkers, refinery fuel, crude for direct burning, oil from non-conventional sources and other sources of supply. Oil supply is total production comprising crude oil, condensates, NGLs, oil from non-conventional sources and other sources of supply.

 
The supply curve (blue line), continues to rise as non-OPEC production has helped to supplement a fall-off in OPEC production. The likelihood of this trend continuing is uncertain, due to expected production declines in Iran, Venezuela and Libya and is reflected in the moderating pace of growth. However, demand has grown strongly – fuelled by global growth trends – over the past year (grey line), and is expected to maintain a pace ahead of supply through 2019, maintaining the current trend of high oil prices.

 

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