How low can it go? Get ready for $10 oil
At about $60 a barrel, crude oil prices are nearly half their peak of $107 in June last year. They may fall more, perhaps even as low as $10 to $20.
Here's why:
US economic growth has averaged 2.3% a year since the recovery started in mid-2009 - about half of what you'd expect in a rebound from the worst recession since the '30s. Meanwhile, growth in China is slowing, is minimal in the eurozone and negative in Japan. Throw in the improved petrol consumption of US vehicles and other conservation measures, and it's clear why global oil demand is weak and might even decline.
At the same time, output is climbing, thanks in large part to increased US production from hydraulic fracking and horizontal drilling. US output rose by 15% in the 12 months to November from a year earlier, based on the latest data, and imports declined 4%.
And there is something else in the mix: the eroding power of the Opec cartel. Like all cartels, the organisation is designed to ensure stable and above-market crude prices. But those high prices encourage cheating when cartel members exceed their quotas. For the cartel to function, its leader - in this case, Saudi Arabia - must accommodate the cheaters by cutting its own output to keep prices from falling. But the Saudis have lost market share when they have done this.
So the Saudis, backed by other Persian Gulf oil producers with sizable financial resources - Kuwait, Qatar and the United Arab Emirates - embarked on a game of chicken with the cheaters. On November 27, Opec said it wouldn't cut output, which sent oil prices off a cliff. The Saudis figure they can withstand low prices for longer than their financially weaker competitors, who will be the ones to cut production first when pumping becomes uneconomical.
What is the price at which major producers chicken out and slash output? Whatever that price is, it is much lower than the $125 a barrel Venezuela needs to support its mismanaged economy. The same goes for Ecuador, Algeria, Nigeria, Iraq, Iran and Angola.
Saudi Arabia requires a price of more than $90 to fund its budget. But it has $726-billion (about R8.5-trillion) in foreign currency reserves and is betting it can survive for two years with prices of less than $40 a barrel.
Furthermore, the price when producers chicken out isn't necessarily the average cost of production, which for 80% of new US shale-oil production this year will be $50 to $69 a barrel, according to Daniel Yergin of energy consultant IHS Cambridge Energy Research Associates.
Instead, the chicken-out point is the marginal cost of production, or the additional costs after the wells are drilled and the pipes are laid. Another way to think of it: it's the price at which cash flow for an additional barrel falls to zero.
Last month, energy research organisation Wood Mackenzie found that of 2222 oilfields surveyed worldwide, only 1.6% would have a negative cash flow at $40 a barrel. That suggests there won't be a lot of chickening out at $40. Keep in mind that the marginal cost for efficient US shale-oil producers is about $10 to $20 a barrel in the Permian Basin in Texas and about the same for oil produced in the Persian Gulf.
Also consider the conundrum financially troubled countries such as Russia and Venezuela find themselves in: they desperately need the revenue from oil exports to service foreign debts and fund imports. Yet the lower the price, the more oil they need to produce and export to earn the same amount of dollars, the currency used to price and trade oil.
With new discoveries, stability in parts of the Middle East and increasing drilling efficiency, global oil output will rise.
US crude oil production is forecast to rise by 300000 barrels a day during the next year from 9.1million now. Sure, the number of drilling rigs is falling, but it's the inefficient ones that are being idled, not the horizontal rigs that are the backbone of the fracking industry. And Iraq's recent deal with the Kurds means that another 550000 barrels a day will enter the market.
While supply climbs, demand is weakening. Opec forecasts demand for its oil at a 14-year low of 28.2million barrels a day in 2017, 600000 less than its forecast a year ago and down from current output of 30.7million. It also cut its 2015 demand forecast to a 12-year low of 29.12 million barrels.
Although the 40% decline in US petrol prices since April last year has prompted consumers to jump at thirstier cars, drivers have been buying more fuel-efficient vehicles.
At the same time, slowing growth in China and the move from energy-intensive manufacturing and infrastructure to consumer services is depressing oil demand. China accounted for two-thirds of the growth in demand for oil in the past decade.
So look for more big declines in crude oil and related energy prices.
- Bloomberg