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Is There Equilibrium in Oil?


  • Production costs are below current prices and reserves are constantly growing.
  • OPEC’s rosy forecast of $70 a barrel in 2020 is based on a model excluding any disruptions from electric engines or renewable technology developments.
  • Demand in developed countries is declining and the trend might spill over to developing countries.

Introduction

Oil prices above $100 a barrel seem impossible but they were a common thing just two years ago. 2014 was the worst year for oil as it tumbled more than 50% from above $100 to below $50 a barrel. In January 2016, oil reached lows not seen since 2001 and 9/11 with prices below $30. The current price of oil quickly rebounded from those lows and is currently around $45 a barrel.

1 figure oil prices
Figure 1: Oil prices 10-year chart. Source: Nasdaq.

As oil is a commodity, its price is formed by the levels of supply and demand for it and future expectations. This article is going to analyze the oil market and look for an equilibrium price in order to make oil related investments easier to assess.

Oil Supply, Demand and Stock Levels

The first thing to look at is the US stocks of crude oil.

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Figure 2: Weekly ending stocks of crude oil and petroleum products. Source: U.S. Energy Information Administration.

The current stocks are at an historically high level and the recent uptrend is easily correlated with the slump in oil prices. A look at supply and demand is necessary to see if the stock levels are just going to grow higher or there is a possibility for further increases in oil prices.

Oil Supply and Demand

A look at oil supply has to be global as the costs of shipping oil around the globe are also at historic lows. World oil supply has been surging as new technologies like shale oil extraction became a profitable investment with high oil prices.

3 figure world oil supply
Figure 3: World oil supply. Source: International Energy Agency.

Global oil supply increased by more by 5.5% from 2013 and only started to decrease in Q1 2016 as high cost producers are slowly forced out of the market. But, demand is still below supply as producers are hoping for a rebound in oil prices and therefore keep production alive.

4 figure world oil demand
Figure 4: World oil demand. Source: International Energy Agency.

The daily average production oversupply is consistently around 0.5 and 1 million barrels. For a sustainable rebound in oil prices that daily oversupply has to vanish.

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Figure 5: Oil supply and demand. Source: Yardeni Research.

A look at producing costs, resources and potential output will give us an answer to the long term oil outlook.

Production Costs and Potential Output

The average production costs per country show that production costs are far below the current oil price except for the UK.

6 figure oil production costs
Figure 6: Oil production costs by country. Source: The Wall Street Journal.

Usually production costs are the ones that set a bottom to commodity prices and therefore it seems from the above figure that lower prices are more probable than higher prices.

Reserves and Output

Currently the global proved oil reserves amount to 1,700.1 billion barrels, which is sufficient to meet 52.5 years of global production. Even with increased oil production, oil reserves have increased by 24% over the past decade. Oil reserves to production ratios show that there is plenty of new potential output if prices increase which can easily bring prices down again.

7 reserves to production
Figure 7: Reserves to production ratios. Source: BP.

High reserves and low production costs are not the only trouble for oil producers, maybe the most important one is that as the world develops less oil is needed due to higher environmental standards, improved energy efficiency and increased support for renewable energy. The decrease in demand from OECD countries shows how important and dangerous for oil this is and can be.

8 figure oil OECD demand
Figure 8: Demand for oil in OECD and developed countries. Source: Yardeni Research.

Oil demand in developed countries peaked in 2006 and is not growing any more. With China slowing down and fuel efficient and electric technologies quickly spilling over globally, the outlook for oil is not bright. The OPEC (Organization of the Petroleum Exporting Countries) forecasts oil prices of $70 a barrel in 2020, $123 by 2030 and $160 by 2040 including inflation. These forecasts have to be taken with a grain of salt as oil producers tend to be overoptimistic creating forecasts based on models that use current data and trends while excluding the influence of disrupting technologies and cost saving oil exploitation methods and keeping reserve levels fixed. Based on current trends OPEC forecasts oil demand growth of only 0.7% per year up to 2040. Similar forecasts were made in 2009 when Goldman Sachs forecasted oil prices of $200 a barrel based on the continuation of previous trends. Therefore, the OPEC scenario should be used as the best case long term scenario.

Conclusion

Oil reminds of phone lines: once essential and now almost obsolete. Investors always have to be aware of secular trends and assess their risks properly. Oil prices and oil related investments are going to be volatile for sure, but the low production costs, high reserves and new technologies do not create a positive outlook. As supply can easily cover demand, no spikes in demand are forecasted as the world is turning to cleaner and renewable energy sources. Oil exploitation is in a declining trend and stocks should be considered only as cash cows. High and expensive exploration projects like Royal Dutch Shell’s Arctic explorations should be avoided as only low cost producers with high reserves should be considered. As the low cost producers are mostly state-owned, finding the best investment necessitates proper understanding of the oil sector and due diligence. As a general investment, oil currently does not show any long term positive catalysts. Short term spikes are always possible.

 

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