Wednesday, November 26, 2014

Oil prices - short term considerations & long term perspective

As recent oil news make headlines we have decided to take a closer look at the OIL price and provide a perspective in considerations of few significant industry and geopolitical trends.

Fossil oil is and will play a significant role in satisfying global energy demand. The medium to long-term trend is determined by multiple factors such as among others: the status of the global economy, geopolitical events, technological advances as well as consumer choices. The two main variables impacting supply and demand have been on the one hand a significant increase in the energy demands of developing countries, and on the other hand the emerging of a wider variety of energy supply typologies (i.e. oil sands, fracking technology) altering the traditional energy supply routes and therefore also geopolitical choices.


In 2013 crude oil global consumption grew around 1.3 million b/d (+1.4%), with an average of 90.4 million for year. The Energy Information Administration forecasts an increase of 1.1 million b/d in 2014 and 1.4 million b/d in 2015.
In the medium-term period (2012-2018) Reference Case Demand could increase by an annual average of 0.9 mb/d, reaching 94.4 million b/d in 2018. Europe, Asia and Russian demands are rising very slowly, as illustrated in Table 1 while developing countries demand rise faster, with an increase of 1.1 mb/d every year.
The outlook for the second half of 2014 shows that the oil demand of non OECD countries will be higher compared to the OECD countries.

Table 1 Medium-term oil demand outlook in the Reference Case[1]
Source: World Oil Outlook 2013

In the long-term period (2012-2035) Reference Case Demand could reach an increment of 20 mb/d each year, this value could rise up to 180,5 mb/d in 2035. The biggest share of this forecasted increase should come from developing countries.

Table 2 World oil demand outlook in the Reference Case

Source: World Oil Outlook 2013

Oil and other liquid combustibles global supply is estimated to grow 1.5 mb/d in 2014 and will decrease to 0.9 mb/d in 2015. Nevertheless, Non-Opec countries supply presents an estimated upward trend, with forecasts assessed at around 1.8 mb/d in 2014 and 1.1 mb/d in 2015.

Figure 1 Change in non-OPEC supply, 2012–2018
Source: World Oil Outlook 2013

In the medium-term 2012-2018, as illustrated in Figure 1, total non-Opec supply is expected to constantly rise by 5.7 mb/d. The two main variables impacting these estimates are the supply of “tight oil” and “oil sands”.
These could create additional supply, in particular in Latin America (Brazil and Colombia), in Middle East and Africa, even if in those countries supply may be negatively affected by political instability.

EIA’s data show that crude oil Opec production had an average of 29.9 mb/d in 2013, with a decrease of 1 million with the respect to the year before, due to the oil production outage in Libya, Nigeria and Iraq. This decrease is partially mitigated by a strong growth in non-OPEC country supply.
The EIA outlook indicates that Opec production should decrease of 0.3 mb/d in 2014 and by other 0.2 mb/d in 2015.

In fact, 8 of 12 Opec members, present a negative production in 2013, such as Libya. The other 4 countries try to maintain a stable production, furthermore, Iraq increase its production from 1.75 mb/d to 3.25 mb/d starting from 2005 to 2013. OPEC conservative production allowed to preserve oil price around 100-110 dollars per barrel during the last few years.

The graphic below, reported by Kent Moors, Phd, in Money Morning, shows that demand will continue to grow until 2025, while supply instead is expected to decline. Based upon these estimates it is possible to experience  a shortfall between demand and supply.

Figure 2 World oil demand and supply

Source: Money Morning 2014


Lately crude oil forecasts depend heavily on the oil exporters geopolitical uncertainty. The reduced risk to Iraqi oil exports and the news regarding increasing Libyan oil exports contributed to a drop in the Brent crude oil spot price to an average of $107 per barrel in July2014, $5/bbl lower than the June average, as reported in EIA outlook of August 2014.

The Saudi active intervention in price setting over the past few weeks, coupled with further signs of a weakening of the Chinese economy have both contributed to driving the price to a 4 years low ($80 USD/bbl). Some add that there may be geopolitical interests at play to further weaken Russia by virtue of keeping the price of oil particularly low. Regardless of the geo-political reasons behind this short term oil price low, it is reasonable to expect a medium term increase to a more reasonable price level, especially if the US economy confirms its acceleration as indicated by the latest indicators released by the Federal Reserve.

Based upon recent events oil price forecasts are highly uncertain, and the current values of futures and options contracts suggest that prices could differ significantly from the forecasted levels. Implied volatility averaged 16 %, establishing the lower and upper limits of the 95% confidence interval for the market's expectations of monthly average WTI prices in November 2014 at $84/bbl and $111/bbl, respectively. Last year at this time, WTI for November 2013 delivery averaged $103/bbl and implied volatility averaged 21%. The corresponding lower and upper limits of the 95%confidence interval were $85/bbl and $125/bbl.

Figure 3 Uncertain oil prices are expected to fall
Source: IMF 2014

According to World Oil Outlook (2013), the nominal OPEC Reference Basket price[2] will be remain on an average of $110/bbl until 2020, and then it will increase in both real and nominal terms.
In nominal terms, we suppose that the nominal price will reach $160/bbl within 2035, whereas in real terms it will reach $100/bbl. It represents a slight shift upward than WOO 2012 expected.

Table 3 OPEC Reference Basket price assumptions in the Reference Case
Source: World Oil Outlook 2013


Eventually, oil price is set to rise, influenced by fear and uncertainty from Middle Eastern and North African countries. The new geopolitical instability of the late 2014, continued nowadays in Iraq and in all Middle East, causes oil production shortages that could take oil price back up to $110-120/bbl.
We judge the existing low price as temporary and due to the following conjunction of few geopolitical and economic events: a slow down in Chinese manufacturing output, Saudi oil discounting IS heavily discounted although limited supply. We acknowledge the above as short-term temporary factors.
Although we expect oil prices to rise in the long-term (2014-2035) we forecast that any sustained price above $150 USD maintained for a long period of time is going to accelerate the oil for gas substitution trend. We therefore believe that the probability of high OIL prices for a sustained period of time is be quite low.
Oil price is closely connected to the futures market, that forecasts an increase oil price and it is minor influenced by the production.
As political instability grows in key oil producing areas and extraction technology progresses, oil companies have more incentives to explore and extract oil in international waters away from conflict areas. Thanks to new technologies these new offshore areas are now within reach.


EIA, Short-Term Energy Outlook August 2014, Energy Information Administration, U.S. Department of Energy: Washington, DC.
Kent Moors, Money Morning, August 2014
IMF (2014), Regional Economic Outlook. Update: Middle East and Central Asia Department, International Monetary Fund: Washington, DC.           
OPEC (2013), World Oil Outlook, Organization of the Petroleum Exporting Countries, Publications: Vienna.

Authors: Marta Pezzoni & Luca Gorlero

[1]The Reference Case scenario in the World Oil Outlook 2013 indicates that demand for energy is expected to increase by 52% over the projection period 2010–2035. As for oil, its demand increases by around 20 million barrels a day (mb/d) in the years to 2035, representing the first upward revision in oil demand growth since the WOO was first published.
[2]Introduced on 16 June 2005 from World Oil Outlook, is currently made up of the following: Saharan Blend (Algeria), Girassol (Angola), Oriente (Ecuador), Iran Heavy (Islamic Republic of Iran), Basra Light (Iraq), Kuwait Export (Kuwait), Es Sider (Libya), Bonny Light (Nigeria), Qatar Marine (Qatar), Arab Light (Saudi Arabia), Murban (UAE) and Merey (Venezuela).

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