Are We There Yet?

Wall Street has an old saying: “They don’t ring a bell at market tops or bottoms.” The same is true of the oil market. At market bottoms the handwringing and angst are intense, while at market tops euphoria over ever-rising prices overwhelms all doubts. In each case, sentiment is proved wrong.

So how do you tell when we have reached a market top or bottom? More importantly, have oil prices bottomed for this cycle, or could they go lower?

OPEC in Charge

Over the past 40+ years, oil prices have largely been managed by the member countries of the Organization of Petroleum Exporting Countries. Twice a year this group huddles in Vienna to guess about how much of their oil is needed to keep markets well-supplied, yet not over-supplied. In other words, OPEC likes high and stable oil prices. Gauging just how much OPEC crude the world needs requires teams of analysts studying global demand drivers while also estimating oil output from non-OPEC producing countries.

In a totally free market, the supply of oil and its demand would set the price. Instead, we have a quasi-managed market controlled by the judgments of a few bureaucrats. Sitting in their offices, these bureaucrats constantly monitor factors that drive oil demand – the level of global economic activity, how many vehicles are entering the world fleet, how many miles they are being driven, and seasonal weather conditions.  

At the same time, these bureaucrats estimate how much oil may flow from countries around the world and how much OPEC must supply to balance the market. The challenge is that this exercise involves lots of guesses as accurate data is only known with hindsight. Balancing supply and demand is more art than science.

Free Market in Charge

The current price slide began 13 months ago as oil supply exceeded demand. Its pace accelerated at the end of November 2014 after OPEC announced it would maintain current output despite evidence the world’s oversupply was growing. Many oil industry executives and analysts were shocked as they had anticipated Saudi Arabia, OPEC’s informal leader, would cut its output to support high prices. Their belief rested on a Saudi oil official’s statement that $100 a barrel was a fair price, but oil was trading well below that mark.

OPEC’s announcement that henceforth market forces would set global oil prices sent them free-falling.

The price of West Texas Intermediate plummeted by a further 40 percent during the 60 days after OPEC’s declaration, following a 31.5 percent slide from its peak in mid-June 2014 to Thanksgiving Day. Given the damage inflicted on the industry by the price collapse, who would have been brave enough to call a bottom when prices reached $44 a barrel in late January? At that time, every forecast projected significant oil industry capital spending cuts and severely reduced oilfield activity. The service industry aggressively cut workers and pared spending to weather the anticipated industry depression.

Two weeks later, however, spot oil prices had jumped 21.5 percent, yet new industry forecasts called for even further spending and activity reductions. Subsequently, WTI prices gave back those gains.  Since then, prices have been range-bound between $51 a barrel at the bottom and $60 at the top. Does this signal stability? If so, companies prepared and capable of acting are well-positioned to seize first-mover advantage for the next up-cycle. On the other hand, false dawns have ruined many optimistic predictions.

Forecasters are watching resilient U.S. oil production on the one hand and growing Saudi Arabian output on the other. Throw in an Iran-U.S. nuclear deal that unwinds the sanctions holding back Iranian oil from global markets and you have unease about oil price stability. Forecasters are now counting on the potential for higher oil demand – a supposed no-brainer, given low prices.  

Where Will the Demand Come From?

More demand should boost oil prices, but the most recent forecast from the International Monetary Fund has cut global economic growth projections once again, sending them lower by 0.2 percent to just 3.3 percent. The revision reflects weak first-half growth, yet the IMF remains optimistic the economy will rebound during the second half of 2015. However, the IMF’s Chief Economist, Olivier Blanchard, proclaimed that “We have entered a period of low growth.” That is not good news for oil demand.  

The IMF says China’s economy will grow 6.8 percent in 2015, but its confidence in this projection is weakening. A new forecast expects the Chinese economic machine to generate 6.3 percent growth in 2016 and only six percent in 2017. These forecasts are below Chinese government projections calling for seven percent annual growth. Private forecasters see China’s growth this year as low as one to two percent. These forecasts suggest that China, the world’s largest oil importer, may need less oil than previously anticipated.

Absent a robust China, the strength of the economies of Europe and North America become even more important. The U.S. economy continues recovering from the Great 2008 Crisis, but its pace is well below that of past recoveries. Forecasts call for the U.S. economy to grow 2-2.5 percent this year and slightly faster in 2016. These projections depend on continued consumer spending growth, partially driven by the extra money from lower gasoline prices.  

Forecasters point to gasoline consumption in the U.S. being at record levels and that after years of declining or flat vehicle miles traveled, America’s vehicle fleet traveled 3.3 percent more miles in the first quarter of 2015 compared to a year ago. That good news, however, is tempered by data showing driving and gasoline consumption have not risen during the past three months. The question about gasoline volumes is how much of the increase came because refiners wanted to capitalize on record-high refining profit margins. Lately, gasoline inventories have been growing. That should not occur in the peak summer driving season, suggesting that demand may not be as strong as previously believed.  

Europe’s economies continue struggling to gain momentum as their recoveries are held back by social issues, energy costs, labor market weakness and high debt loads in a number of countries as highlighted by the recent Greek-E.U. bailout drama. In the U.K., the government just announced a large increase in the country’s minimum wage but at the same time a roll-back in unemployment benefits, all in an attempt to boost employment. Will it work or merely lead to greater social deprivation? What will be the impact on the U.K.’s energy markets?  

The International Energy Agency, the European organization established to help countries manage energy supply and demand, recently announced: “World oil demand growth appears to have peaked in the first quarter of 2015 at 1.8 million barrels per day and will continue to ease throughout the rest of this year and into next as temporary support fades.” Given the IEA’s demand outlook for the balance of 2015 and 2016, it is hard to see global oil prices moving substantially higher absent greater demand growth.  

Climate Change Repercussions

The nations of the world are also hurtling toward a December climate change conference in Paris with the issue taking on a religious fervor due to the involvement of the Pope. China has indicated it plans to tighten its emissions restrictions and boost consumption of cleaner fuels. However, the Chinese remain on course for rapid expansion of their automobile fleet.  

Recently, the U.S. and Brazil agreed to work to reduce their carbon emissions, but one country is entering a recession while the other’s efforts are being restrained by the courts. If the world agrees to the climate change treaty, hydrocarbon fuels will be under siege, further restricting their use.  

While there are certainly many forces at work to reduce oil’s use, the reality is that hydrocarbon fuels will remain the primary source of the world’s energy for decades to come. Nonetheless, unrelenting social and economic pressure will be applied to lower oil consumption. The question is just how much it can be reduced without derailing economies around the world or punishing residents of developing economies. Concurrent with demand pressures will be growing battles over expanding crude oil exploration and development activity around the world and especially in unconventional energy areas.  

The New Reality

Despite these crosscurrents, it is likely global oil prices have experienced their low for this cycle. That said, it doesn’t mean oil prices will experience a sustained upward move. Rather, we are likely to spend the next year in a world buffeted by prices swinging between lows of $48-52 a barrel and highs of $60-64.

Will that provide sufficient incentive for global oil producers to continue delivering additional supplies to meet increased demand? We believe so. However, it likely means the petroleum industry must become more efficient and cost-effective than it has been. It also means the U.S. petroleum industry will provide less economic stimulus during the next few years than it did in the early years of the current recovery. Overall, that’s not a positive message.