There is an urge – maybe an urgent urge – to speed up the energy transition. There is much progress but we should also keep an eye on the dynamics of the energy markets. Nick Butler provides a good blog in the Financial Times about the latest trends in the oil market.
Too soon to declare the end of the oil downturn
The prospect of a partial freeze on oil production at current levels. Some upbeat numbers from China. A couple of days of rising prices on the market.
These signals are enough, it seems, to make some traders excited and to produce headlines announcing the end of the downturn and a turning point in the global commodities cycle. The reality, however, is more complicated.
Let’s focus on the oil market.
The most important point is that things have stopped getting worse. Daft predictions that oil prices would fall to $20 or less have been proved wrong. The Saudis have finally accepted that their strategy of trying to force US tight oil producers and others out of the market has failed; the production freeze signifies a reluctant acceptance in Riyadh that to persist would do more harm to the kingdom and its allies than to anyone else.
A freeze is better than nothing — but it is not sufficient to push prices up, and that is where the traders could be caught out. There are three reasons for taking this view.
In the past year there has seen a build-up of oil stocks across the world. Those stocks need to be run down before the market can rebalance. The process depends on the pace of demand growth. In the US, Europe and Japan, it is flat to negative. The International Monetary Fund has just adjusted downward most of its economic forecasts for both the OECD and the developing world for 2016. Chinese demand is certainly high; imports of 8m barrels a day were recorded in February but it is not clear how much of that represented buyers taking advantage of low prices to build reserves. Until there is a sustained surge in demand, the level of stocks will overhang the market. Everything else being equal, it could take two years or more to reach a new balance at recent growth rates.
But oil markets are dynamic, and highly sensitive to changing circumstances.
A slightly higher price as a result of the freeze — say $45 or even $50 a barrel — will bring on more production; not least in the US, where 500,000 barrels a day has been shut in over the last year. The owners of that output, and the people who have lent them money, will be keen to see some revenue flowing.
On top of that several other countries are itching to produce more — starting with Iran, which even without full removal of sanctions should be able to add 350,000 to 400,000 barrels a day to its exports this year. Numerous other countries, from Brazil and Venezuela to Iraq, would like to increase output in order to support their national economies. Don’t forget that a price of $45 a barrel is still 60 per cent below the level of two years ago. Many countries are finding it very hard to make the adjustment in their budgets to accommodate that fall. The odds on the freeze holding are very slim.
The production freeze will tell us where the ceiling on oil prices lies. The cost savings achieved around the world have lowered the ceiling. Tight oil producers in the US were expected (not least by the Saudis) to go out of business when the prices fell below $80. Some now say they can break even at $50 and are hopeful of getting that threshold of profitability even lower. This sets a new cost base for the future. So do the savings achieved in mature areas such as the North Sea. The reality is that the potential for supply growth, even at prices of $45 or $50, is still higher than the likely growth in demand.
There is only one conclusion to be drawn from all this.
If the oil producers want a substantially higher price — meaning $70 or $80 a barrel — they will have to cut production. The cut will have to be sharp and to last for quite a long time. When the Saudis accept this it will be safe to say that the downturn in the oil market is coming to an end. We are not there yet.