Running down the oil stimulus Part 2

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In part 1 of the blog we modelled the impact of running down the oil stimulus on the global economy. The resulting drag was quite sizeable with the world economy growing in the next two years at its slowest pace since 2009.

We had promised that the second part of the blog would deal with the likelihood of this scenario becoming reality. The OPEC meeting last Friday gave us a good indication as to where oil prices are heading; and for now the market view is that the only way is down.


Friday's meeting

OPEC decided not to decide on a new supply quota, allowing for a free-for-all policy for members of the cartel. The lack of agreement on a new supply quota means that OPEC countries are unrestricted to raise their oil supply by as much as they want. Iran which will see sanctions lifted next year has already vowed to flood markets with its oil, and so has Iraq. The reaction to the OPEC meeting was a further slump in the oil price to its lowest level in seven years.


The end of OPEC?

Commentators have jumped to pronounce the end of OPEC with the latest meeting adding to suspicions that the Saudi strategy would eventually lead to the dismantling of the cartel.  A definitive answer to this question is hard to find.

The Saudi’s strategy to refrain from production cuts to prop up prices, aiming instead to fight for market share as it outlives higher cost producers has added to tensions within OPEC. Cracks in the cartel have become increasingly evident in the latest OPEC meetings, with high-cost producers like Venezuela and Nigeria feeling the pain of the Saudis’ strategy.

It has not been painless for low-cost producers either, including the Saudis, who are finding it hard to balance their budgets, financing deficits through the foreign reserves built up in the good years of oil prices above $100 p/b. But the Saudis are not in the mood to back down, especially as their strategy is starting to pay off with non-OPEC output expected to fall next year.

But despite cracks within OPEC widening, tensions between cartel members are by no means a new thing. Saudi strategy – the OPEC’s most influential member – has often diverged from that of the rest of the cartel, in the 1980’s, 1990’s and 2000’s.  What is more, the Saudis are in it for the long-term; they want to re-establish the control of OPEC on the oil market, to the potential benefit of everyone in the cartel.

In this regard, the OPECs non-decision on Friday is no surprise and claims of the dismantling of OPEC are perhaps premature. It’s true however, that the conflicts in Syria and Yemen, where the cartel’s two most powerful members Saudi Arabia and Iran have diametrically opposed positions is adding another layer of complexity for the future of OPEC.


A new bottom?

The latest OPEC meeting has also raised questions about a new bottom for oil prices, with figures as low as $20 p/b cited. The record short-selling of oil stocks since the meeting as traders bet on lower oil prices is compounding this view. But what are the factors that are likely to determine the bottom in oil prices?

An oil price at $37 p/b is more than enough to force losses on high-cost producers with no need for further price declines. So far, producers in the US, Canada, Russia and elsewhere have continued to pump output, as many high cost producers are incentivised to continue to produce even at a loss. However, there are question marks around how long this can go on for with Russians being progressively priced out of the market, shale gas rig counts in the US dropping and investment in the sector drying up fast.

As such, the direction of oil prices in 2016 will likely depend on three factors. The degree of spare capacity within OPEC producers (aka their ability to continue increasing crude supply), growth in global demand for oil and the speed at which US and Canadian producers can develop new technologies to lower production costs.

There in another wild card in the equation; the reason why Saudis may be pushing oil below $40 could be to counter the threat of an emerging Iran-Iraq alliance. As mentioned above, an oil price below £50-£60 p/b is already enough to push out shale gas. On the other hand, Iran and Iraq have a lower cost of production and their combined oil output would dethrone Saudi Arabia as OPEC’s de facto leader. This means that the oil price could go even lower than $40 p/b and that end to the supply glut could be pushed further down the road.


Where does this leave us?

The oil price looks to be close to its bottom as we go into 2016, with the possibility of some further declines not ruled out. We are likely to see significant volatility around the $30-$50 p/b price band until supply and demand fall back into balance possibly in the second half of 2016. The oil price that is expected to balance the market is at about $60-$70 p/b in 2016, with prices likely to fluctuate around that level for the next few years.


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