NS3040 Winter Term 2015 Causes the 2014-15 Oil Price Decline

Introduction

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Main Points: Oil prices fell sharply in the second half of 2015 Ended four year period of stability around $105 per barrel Decline is much larger than that of other commodities Oil prices are expected to remain low in 2015 and rise only marginally in 2016 Sources and implications of the sharp decline in oil prices have lead to intensive debate

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Questions How does the recent decline in oil prices compare with previous episodes?

What are the causes of the sharp drop?

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Oil Prices

Oil Price Patterns I

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Oil Price Patterns II

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Comparison with Previous Episodes Between 1984-2013 five other episodes of oil price declines of 30% or more in a six month period occurred These coincides with major changes in the global economy and oil markets:

• An increase in the supply of oil and change in OPEC policy (1985-86) • U.S. recessions 1990-91 and 2001 • The Asian crisis 1997-98, and • The global financial crisis (2007-09 4

Oil Price Patterns III

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Oil Price Patterns IV

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Many parallels between the recent episode and the collapse in oil prices in 1985-86.

After the sharp increase in oil prices in the 1970s, technological developments made it possible to

• Reduce the intensity of oil consumption and • Extract oil from various offshore fields including the North Sea and Alaska

After Saudi Arabia changed policy in December 1985 to increase its market share

• Price of oil declined by 61 percent between January-July 1986

Following this episode low oil prices prevailed for more than 15 years.

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Oil Price Patterns V

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In other commodity markets, episodes of large price declines:

• Have mostly been observed in agriculture, typically associated with specific weather conditions

After reaching deep lows during the global financial crisis most commodes peaked in the first quarter of 2011 Since then prices of metals and agricultural raw materials have declined steadily as a result of weak global demand and abundant supplies In contrast oil prices fluctuated within a narrow band around $105/barrel until June 2014 Softness in the global economy was offset by concerns about geopolitical risks, supply disruptions and production controls exercised by OPEC

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Oil Price Patterns VI

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Apparent that stability until recently

• Reflected in part willingness of Saudi Arabia and • Other low cost producers to withhold output in support of OPEC price objectives

Steep decline in second half of 2014 intensified after change in policy at the OPEC meeting in late November By end of 2014 cumulative fall in oil prices from the 2011 peak was much larger than non-oil commodity prices Currently (early January) the oil markets have gone into are in contango – all spot markets are cheaper than forward contracts When spot prices produce the same profits as purchasing and storage for future sales, markets have stabilized – may be nearing that point soon.

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Oil Price Patterns VII

Commodity Price Indices

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Oil Price Patterns VIII

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Contango and backwardation in oil futures markets

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Oil Price Patterns IX

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WTI Futures Curves, 2014

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Causes of the Oil Price Drop I

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Causes of the sharp drop For any commodity, underlying demand and supply conditions for oil determine the long run trend in prices Short term movements in market sentiment and expectations (in some cases driven by geopolitical developments and OPEC decisions exert influence too Prices may drop rapidly to surprises in the news even before actual changes occur In 2014 relevant events included

• Geopolitical conflicts in some oil producing regions • OPEC announcements and • The appreciation of the U.S. dollar

Long term developments in supply and demand have also played important roles in driving the recent decline in oil prices

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Causes of the Oil Price Drop II

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Trends in supply and demand Recent developments in global oil markets have occurred against a long term trend of greater than anticipated supply and less than anticipated demand Since 2011 US shale oil production has persistently surprised on the upside by some 0.9 million barrels per day – about 1% of global supply in 2014 Expectations of global demand have been revised downwards on several occasions during the period as economic growth disappointed.

Global growth in 2015 is expected to remain much weaker than it was during the 2003-08 period when oil prices rose substantially The oil-intensity of global GDP has almost halved since the 1970s -- result of increasing efficiency and declining oil intensity of energy consumption

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Causes of the Oil Price Drop III

IEA Forecast of World Oil Demand

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Causes of the Oil Price Drop IV

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Change in OPEC Objectives Saudi Arabia has traditionally acted as the cartel’s swing producer Using its spare capacity to either increase or reduce OPEC’s oil supply and stabilize price within a desired band Changed dramatically in November 2014 after OPEC failed to agree on production cuts The OPEC decision to maintain production level of 30mb/d signaled a significant change in cartel’s policy objectives From targeting an oil price band to maintaining market share No doubt changed position reflects concern over increased competition from shale

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Causes of the Oil Price Drop V

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Receding geopolitical concerns about supply disruptions In second half of 2014 became apparent that supply disruptions from conflict in Middle East hand unwound Or did not materialize as expected In Libya despite internal conflict production recovered by 0.5 millin barrels a day (about 0.5% of global production) in the third quarter of 2014 In Iraw, as advance of ISIS stalled, became apparent that oil output could be maintained.

In addition the sanctions and counter sanctions imosed after June 2015 as a result of the conflict in Ukraine aave had little effect on oil and natural gas markets thus far

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Causes of the Oil Price Drop VI

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U.S. dollar appreciation In the second half of 2014 the U.S dollar appreciated by 10% against major currencies in trade-weighted terms A U.S. dollar appreciation tends to have negative impact on the price of oil

• demand can decline in countries that experience an erosion in the purchasing power of their currencies

Empirical estimates very greatly

• The high estimates suggest a 10 percent appreciation is associated with a decline of about 10 percent in the oil price • Low estimates suggest a 3% or less 17

Causes of the Oil Price Drop VII

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Speculation Beyond traditional demand and supply factors some have suggested “financialization” of oil and other commodities as a factor leading to the price decline Leads to greater likelihood of speculation in commodity markets Little hard evidence that this is the case in the recent price drop Latest IEA report indicates that oil inventories reached their highest level in two years Suggests expectations were of a price increase not decrease

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Short-Term Drivers of Oil Price Decline I

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Short-Term Drivers of Oil Price Decline II

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Short Term Drivers of Oil Price Decline III

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Long Term Drivers of Oil Price Decline I

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Long Term Drivers of Oil Price Decline II

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Future Supply Conditions I

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2. How persistent is the supply shift likely to be?

Depends on two factors

• First is whether OPEC and in particular Saudi Arabia will be willing to cut production in the future • This depends in part on the motives behind the change in its strategy and the relative importance of geopolitical and economic factors in that decision.

One hypothesis is that Saudi Arabia has found it too costly in the face of steady increases in non-OPEC supply to be the swing producer and maintain a high price

• If so and unless the pain of lower revenues leads other OPEC producers and Russia to agree to share cuts in the future – strategy unlikely to change 24

Future Supply Conditions II

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Another hypothesis is that it may be an attempt by OPEC to reduce profits, investment, and eventually supply by non-OPEC suppliers – some of whom face much higher costs of extraction than the main OPEC producers The Second Factor is how investment and in turn oil production will respond to low oil prices.

There is some evidence that capital expenditure in oil production has started to fall One estimate is that overall capital expenditure of major oil companies is 7 percent lower for the third quarter of 2014 compared to 2013 Available projections indicate that capital expenditures will fall markedly throughout 2017

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Future Supply Conditions III

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Future Supply Conditions IV

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For unconventional oil such as shale (which now accounts for 4 million out of a world supply of 93 million barrels a day), the break even prices – the price at which it becomes worthwhile to extract in the U.S. are typically below $60 per barrel At prices around $55 per barrel, projections suggest that the level of oil production could decline but only moderately by about less than 4 percent in 2015 Rates of return will be significantly lower However, some highly leveraged firms that did not hedge against lower prices and are already under financial stress and have been cutting their capital expenditure and laying off significantly

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Future Supply Conditions V

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2. Supply Conditions VI

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Break-Even Prices for U.S. Shale basins

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Future Supply Conditions VII

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Other things being equal the dynamic effects on supply should lead to a decrease in supply relative to the initial shift and thus to a partial recovery of prices This is what is suggested by futures markets which now show an expected recovery of prices to $73 a barrel by 2019 The uncertainty associated with these forecasts comes not only from supply, but also demand factors On the supply side:

• Possible changes in OPEC’s strategy and • geopolitical tensions in Libya, Iraq, Ukraine and Russia should not be underestimated 30

2. Supply Conditions VIII

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On the demand side

• Uncertainty about global economic activity and thus the derived demand for oil remains high • Shown by the size of the implied distribution of futures prices (based on options prices) • The 68% confidence band for the price in 2019 ranges from %48 to 485, the 95% band from $38 to $115% -- very large band by historical standards 31

IMF Forecasts January 2015

WTI Crude Forecasts

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