Crude Oil Price Decline – To What Price?

By: Andrew_McKillop

Triple Digit Prices are Not Forever
In what is only superficially amazing at a time when Islamic insurgency, including Boko Haram in Nigeria and ISIS in Iraq may be threatening the state, civil society and the oil sector in major exporter countries, oil prices are declining quite rapidly. The “magic three digit” price level for oil - $100 a barrel  come rain or shine – has been seriously eroded for US WTI and may soon also be attacked for Brent. The major reason for this decline is sharper than expected and forecast decline in leading economic indicators for many large importer countries, including Japan and the EU28. Monthly oil import demand outturns for China and India are variable, but have suffered major contractions relative to previaling rates before 2010.

Ample supply is also cited as a cause of price erosion, by oil analysts and this is demand-related on the global level, but is not demand-related in the key example of US shale oil output growth. US shale output growth is raising domestic oil supply for a domestic market that is “flat” or only in very slow growth.  US shale oil supply growth is almost totally disconnected from the domestic demand side. The simplest of oil-sector indicators, like oilinventories at Cushing OK tend to show this.

The Fundamentals
Broadly speaking and related to the Peak Oil paradigm, there was “incipient structural shortage” of oil, worldwide, before the 2008 economic crisis and its sequels. This helps explain the fantastic run-up in prices as shown in the chart, below from the US EIA to 2008

Through 2002-2008 there was an almost straight-line run-up of prices, making forward bets on prices all that easier! In fact, the Peak Oil paradigm became a self-fulfilling hypothesis (see my article: http://www.marketoracle.co.uk/Article46846.html) with major ramifications in public policy, including the large support given to energy saving, “low carbon “ energy and oil substitution, but with different timelines for concrete impacts in the real economy.

Unsure and variable, easily qualified and disputed break-even producer cost estimates for WSB-Western Sedimentary Basin Canadian oilsand liquids, for example, place these in the $60-per-barrel ballpark as of today. However, major actors in WSB oilsands in the period 2000-2005 such as Royal Dutch Shell claimed that when and if “carbon credits” were added to the equation, breakeven production prices could be cut to as low as $30 per barrel.

Supply-side fundamentals, when mixed with geopolitics, produce the Genel Energy phenomenon where this oil producer nearly exclusively focused on Kurdistan can source oil supply at very low prices relative to still-current market rates. Although vigorously disputed by General Energy, this may include supply to Genel Energy, for resale, of Kurdish oil at “around $50 per barrel”.

The 2008-2009 Price Collapse
This is already today a heavily discussed subject area with a large number of potential interpretations (see eg OIES study http://tinyurl.com/lm9cnxj), but the key role of a rapid decline in global demand for oil, especially imported oil was a certain driver of the price collapse. In other words this was not a supply-driven or supply-led price collapse.  Also we can note, a key result or key driver of the price decline process in 2008-2009 included firstly a peak in the Brent / WTI differential, or Brent premium, followed by a collapse to almost-identical prices for the two “marker crudes”.

As we know, recent trends for the Brent premium show that this mark-up for Eastern hemisphere oil relative to Western hemisphere oil is “not what it used to be”. It can be compared with the still-existing global natural gas market price premium, on gas outside the US versus gas inside the US.

While such market price premiums held, they certainly affect investment decision on oil and gas, and the breakeven price required for project approval. To be sure, we could expect that oil producers, in particular, will be sensitive to market price outlooks and scenarios, but simply the persistence of a large Brent / WTI premium directly led to very high cost, high break-even investment decisions in the Eastern hemisphere, for example the ENI-led Kashagan project, BP's pipeline and other oil projects in west Asia, and the Chinese and Indian national decisions to start SOR-Strategic Oil Reserves.

Overall however, nothing prevents a price collapse to far below break-even prices for oil, as in 2008-2009. Signs of this include the alleged ability of Genel Energy to source oil from Kurdistan at around or about $50 per barrel and the probably willingness of KSA to make up any losses of Iraqi output if or when attacks in Iraq by the Islamic State pose a real threat to oil installations. In this second case this it would be comparable to the post-1986 decision by KSA to deny revenues to the Islamic Republic of Iran, engaged in a long war with the Sunni-ruled Iraq of the day. At the time, oil prices collapsed by about two-thirds or 67% in a short period.

By Andrew McKillop

Contact: xtran9@gmail.com

Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

Co-author 'The Doomsday Machine', Palgrave Macmillan USA, 2012

Andrew McKillop has more than 30 years experience in the energy, economic and finance domains. Trained at London UK’s University College, he has had specially long experience of energy policy, project administration and the development and financing of alternate energy. This included his role of in-house Expert on Policy and Programming at the DG XVII-Energy of the European Commission, Director of Information of the OAPEC technology transfer subsidiary, AREC and researcher for UN agencies including the ILO.

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