Prices, Time, Expectations: The Oil Market’s Fuzzy Price Floor

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ReutersBy John Kemp

LONDON, Oct 16 (Reuters) – How far do oil prices need to fall to curb the investment in shale production and stem the destruction of demand?

As the price of benchmark Brent has plummeted almost 30 percent from $114 per barrel in June to just $83 this week, stunned producers and traders have been left trying to predict how much further prices will fall before finding some sort of floor.

The two most popular methods for identifying a potential floor are the fiscal breakeven prices for OPEC members and the marginal costs for North American shale producers, but both approaches have severe limitations.

It is more useful to think about supply and demand responses as a function of time and expectations as well as the absolute price level.

FISCAL BREAKEVEN PRICES

The International Monetary Fund (IMF) publishes breakeven prices for the Gulf producers based on the revenue they need to balance their budgets as part of its annual Article IV consultations with national governments (“Regional Economic Outlook: Middle East and Central Asia Department” May 2014).

In practice, however, producers’ revenue requirements provide only a weak guide, at best, to where the floor in oil prices lies:

(1) OPEC accounts for only 40 percent of global oil production, a share that has been falling, which limits its ability to control prices. Even if the organization’s members could agree on a price that was adequate to cover their spending needs, there is no evidence they would be able to make it effective.

(2) Experience over the last 40 years suggests government spending adapts to available revenues rather than the other way around. Spending and breakeven prices have moved sharply higher during the years of high prices. Even Saudi Arabia’s breakeven price has risen by around $50 since 2008, according to the IMF. No doubt spending could and would have to be cut if prices remained low for any length of time.

(3) Stronger OPEC members (Saudi Arabia, United Arab Emirates and Kuwait) have amassed combined reserves of around $815 billion during the period of high prices that would enable them to run deficits for several years if necessary, so breakeven prices are only a constraint in the medium and long term, which means more than two to three years.

(4) Weaker OPEC members (Venezuela, Iran, Iraq and Nigeria) have combined reserves of less than $200 billion which would be quickly exhausted. But they are likely to resort to foreign borrowing, deficit monetisation and inflation as well as spending cuts to cope with any revenue shortfall; in any event they have little influence over OPEC’s strategy.

MARGINAL COST OF SHALE OIL

The marginal cost of shale production is a more promising approach to defining the floor for prices.

U.S. shale production has contributed most of the incremental growth in output during the past three years so shale is in a sense the marginal barrel in the market (even if it is not actually the most expensive oil).

Moreover, the output from shale wells declines rapidly, so new wells must be constantly drilled and fractured to replace falling output from old ones or output will start to fall.

In theory, it should be possible to identify a threshold price level at which there is not enough new drilling to continue growing shale output.

In practice, reported costs per barrel vary widely between different shale plays and even among producers within the same play. Estimates for the marginal cost of shale production range from as little as $40 to as high as $85.

For the industry as a whole, the marginal supply price is probably somewhere between $65 and $85.

PRICE, TIME AND EXPECTATIONS

A better way of understanding the supply response is to realize that it is a joint function of prices, time and expectations.

The lower prices fall, other things equal, the bigger and faster the response is likely to be from producers. The longer prices remain low the bigger response will be. And it matters whether producers expect prices to stabilize, fall further, or rebound.

The fall in benchmark U.S. prices to around $80 per barrel (for West Texas Intermediate) is probably enough to slow the growth in shale, and eventually rebalance the market, but the process is likely to take years.

If prices declined further to $70 or even $60, the response from shale producers would be larger and the adjustment process would be correspondingly quicker, especially if prices remained at those levels for some months and were expected to remain weak in the medium term.

In contrast, if prices stabilize around $80 in the short term and are expected to recover to $90 or $100 in the medium term, there might be no response at all.

Because the supply response is a function of the passage of time and expectations about the future, as well as the absolute price level, it is impossible to pinpoint a floor price with any meaningful precision. The floor price is “fuzzy.” It could be as low as $60-65 or as high as $90-95.

CONSERVATION AND PROFLIGACY

In the medium term, which is anything from two to five years, lower prices will also drive changes in oil consumption, which would be as important as changes on the supply side.

Just as sustained price increases between 2002 and 2012 eventually produced a substantial drop in oil demand, through changes in legislation, behavior, investment and economic activity, a sustained decline would almost certainly reverse some of this demand destruction, just as it did after prices dropped in 1986.

Again, the change in demand is a function of prices, time and expectations, which means that it is fuzzy. Some aspects of demand destruction could be reversed quite quickly, while others are much more sticky and enduring.

The fastest impact of prices on economic activity is likely to be through consumer spending, business investment and the general level of economic activity.

Falling oil prices represent a positive supply-side shock for the advanced economies, which will improve household budgets and corporate profits (outside the oil and gas sector) by hundreds of billions of dollars per year.

Based on current prices, Ed Morse, global head of commodities research at Citigroup, estimates the global windfall is worth around $660 billion, or a tax rebate in the United States of just under $600 per household.

“The world economy as a whole would enjoy the equivalent of a huge quantitative easing program, helping to spur stalling economic growth,” Morse writes in the Financial Times (“Winners and losers from oil price plunge” Oct 15).

In the longer term, the bigger impact on demand would come from changes in behavior, investment and (possibly) legislation.

High and rising prices spurred substantial investment in fuel-efficient vehicles and other equipment as well as changes in behavior (including a big drop in transport demand) and substitution of cheaper fuels for oil (converting home and businesses heating systems from heating oil to natural gas).

Some changes are deeply entrenched through legislation like the 2005 Energy Policy Act and the 2007 Energy Independence and Security Act, as well as the corporate average fuel economy (CAFE) regulations in the United States, which would be hard to undo.

Other elements are more readily reversible. For example, lower prices would slow the conversion of heating systems from heating oil to gas and probably encourage consumers to start buying heavier and more powerful cars again. Lower oil prices might slow or even halt interest in using gas as a transport fuel in trains and ships.

But again the demand response is a question of price, time and expectations. Of those three, time and expectations are more important than the absolute level of prices.

If oil producers are hoping for a quick drop to $80 followed by an equally swift recovery to $90, $100 or even more, they are likely to be disappointed.

The point about a “good sweating” is that it only works if it is thought likely to last for a long time so the holdouts give up in despair. (Editing by William Hardy)

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