Short-term crude forecasts are, well, crude forecasts - The Daily Reckoning
The Daily Reckoning by Vivek Kaul
On This Day - 13 January 2015
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Short-term crude forecasts are, well, crude forecasts A  A  A

- By Vivek Kaul

Vivek Kaul
"The only function of economic forecasting is to make astrology look respectable." - John Kenneth Galbraith

In response to yesterday's column a journalist friend asked "where do you see the price of crude oil heading in the days to come?". A perfectly innocent question which does not have an easy answer.

First and foremost it is important to understand why the price of crude oil has fallen in the recent past. One explanation lies in the fact that the demand for oil has not risen at the same pace as it had in the past.

As Satyajit Das author of Extreme Money writes in a recent research note titled Reverse Oil Shock: " Weak demand contributes perhaps 30-40 percent of the fall. In 2014, oil demand grew by around 500,000 barrels per day, below the 1.3 million barrels growth projected earlier, reflecting weak economic activity in Europe, Japan and emerging markets, especially China."

At the same time this slow increase in demand has been met with an increase in the supply of oil. With high oil prices, other sources of oil like shale oil in the United States and oil from tar sands of Canada, have also become viable. As Das points out: "Increased supply contributes 60-70 percent of the decline. In a pattern reminiscent of earlier price cycles, several years of high prices and strong demand has encouraged new sources of oil supply to be brought on stream, causing the price to adjust."

The production of US shale oil has gone up by 4 million barrels per day since 2008. This has led to a situation where the United States produces 9 million barrels per day of crude oil, only around a million barrels lower than Saudi Arabia.

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Also, oil from other traditional oil producing countries like Libya has also hit the market in the recent past. Libyan oil production increased by around 800,000 barrels per day after the "reopening export terminals following a truce agreed between tribal militias in the civil war".

To add to all this has been the decision of the Saudi Arabia led Organization of the Petroleum Exporting Countries (OPEC) not to cut production with the fall in oil prices, as it has done in the past. It needs to be pointed out that Saudi Arabia has been a swing oil producer in the past, where it has either increased or decreased its production to ensure that global supply of crude oil equals its demand.

But that hasn't happened this time around as Saudi Arabia hasn't cut production. Why is that the case? On the previous occasions Saudi Arabia cut production it ensured that crude oil prices continued to remain high and in turn, benefited other countries.

As Das writes: "In the mid-1980s, Saudi Arabia cut its output by close to 75 percent to support weak prices. The Saudis suffered a loss of revenues and also market share. Other OPEC members and non-OPEC producers benefited from higher prices. In recent years, Saudi Arabia has regained market share, benefiting from the disruption to suppliers such as Iran, Iraq and Libya." And given this, the Saudis are not in the mood to hand over their market share to other countries.

Hence, they would rather hold on to their market share than cut production and sustain a higher crude oil price. Also, shale oil is expensive to produce and by driving down the oil price Saudi Arabia is trying to make the entire shale oil business unviable.

As Niels C. Jensen writes in The Absolute Return Letter for January 2015 titled Pie in the Sky: "In effect, OPEC is trying to destroy the economics of this industry, which admittedly requires quite high oil prices to remain profitable. Only 4% of total U.S. shale production breaks even at $80 or higher. A high percentage of the industry breaks even with an oil price in the $55-65 range."

Brent crude oil is currently quoting at around $50 per barrel. If crude oil continues to sell at $50 per barrel or lower, it is for sure that US shale oil producers will go bankrupt in the days to come. As Jensen puts it: "OPEC (with Saudi Arabia in the driving seat) may exhaust itself and decide that enough is enough, or it may go for broke - in this case it would want U.S. shale producers to go bankrupt and exit the industry forever which, we note, is quite likely to happen, should the oil price stay at current levels or lower for any extended period of time."

The trouble here is that this assumes that the United States will sit back and do nothing. But as history has shown the politics of oil is never so straightforward. As I had pointed out in yesterday's column the shale oil companies have been major job creators in the United States.

As analyst Jawad Mian points out in the Stray Reflections newsletter for January 2015: "It is undeniable that the oil and gas sector has become a key driver of US economic activity...It has been responsible for about 30% of the 10 million national increase in jobs since the global financial crisis." Oil companies have been major job creators in the states of Alaska, Texas, Pennsylvania, North Dakota, Colorado, West Virginia, Wyoming, Oklahoma and Montana.

Given this, chances are that the US political establishment will not sit back and watch if shale oil firms start shutting down. "It is now a highly political chess game and, as I have learned over the years, when politics enter the frame, logic goes out the window," writes Jensen.

At the same time the shale oil firms are politically very well connected in the United States. This can be made out from the way the shale oil firms are allowed to operate. As Jeremy Grantham writes in the GMO Quarterly Newletter for the third quarter of 2014: "There are few if any constraints, for example, on what chemicals and in what amounts, can be pumped into a fracking well. Nor is the leakage of methane (natural gas) from the drilling and pipeline operations seriously monitored despite the fact that methane is over 86 times as potent a greenhouse gas, at a 20-year horizon, as CO2 is."

This demonstrates the "the remarkable influence of the energy industry over the U.S. governmental process, if "process" is not too dignified a word," writes Grantham. Grantham is one of the most well respected fund managers in the United States. And given what he says, the shale oil companies must already be working the United States government to do something about Saudi Arabia driving down the price of crude oil.

At the same time the US benefits from low oil price as well. "A number of U.S.-antagonistic countries around the world (think countries like Russia, Iran and Venezuela) will be seriously weakened as a result of lower oil prices, which will strengthen the position of the U.S. in global politics," writes Jensen.

Low oil price also benefits the US consumers given that they have more money in their pocket to spend on other things. As Das explains: "Lower oil prices increase disposable income. The average US motorist spends around US$3,000 per annum on gasoline. US households may save around US$500 to US$600 a year. If this money is spent then it will boost growth. There are also indirect channels such as transport costs. It also affects agriculture, which is four to five times as energy intensive as manufacturing."

Given this, it will be interesting to see how the US political establishment reacts to a fall in crude oil prices and that will to some extent determine where oil prices head in 2015, even though it seems that they will continue to remain low in the short term.

Further it is worth remembering that the price elasticity of crude oil is low especially in the short run. This means even a small disruption in supply can lead to oil price shooting up rapidly. As Das puts it: "The structure of the oil market entails fine margins between demand and supply. The current oversupply is around 2 million barrels a day, less than 2 percent of global consumption...Key uncertainties include weather conditions, unanticipated supply disruptions and geo-political factors."

How much role does speculation play in driving up or down the price of oil? Post your comments or share your views in the Equitymaster Club.

Vivek Kaul is the Editor of the Diary and The Vivek Kaul Letter. Vivek is a writer who has worked at senior positions with the Daily News and Analysis (DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. The latest book in the trilogy Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System was published in March 2015. The books were bestsellers on Amazon. His writing has also appeared in The Times of India, The Hindu, The Hindu Business Line, Business World, Business Today, India Today, Business Standard, Forbes India, Deccan Chronicle, The Asian Age, Mutual Fund Insight, Wealth Insight, Swarajya, Bangalore Mirror among others.

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4 Responses to "Short-term crude forecasts are, well, crude forecasts"

sanjay

Jan 13, 2015

Vivek's articles are amazing for decoding macro picture. Wud be great if we can get a quick recap or summary para in end in case we are not able to read thru ..

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SundaraVaradan

Jan 13, 2015

I wanted view comments!

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Rishi Poddar

Jan 13, 2015

I really appreciate the in-depth analysis of the author over the past two days on the implications of oil prices in the Indian and Global context. He has approached the subject from multiple angles and viewpoints and his analysis is outstanding. Thanks a lot.

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bharat shah

Jan 13, 2015

very interesting read on oil prices for a layman!

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