Industry NewsTwelve months ago the question facing everyone in the oil industry was - how high can prices go? With the market boosted by economic growth and increased speculative and investment interest in oil as a commodity, the oil price broke one record high after another with some industry sources predicting $250 per barrel.
However, after prices peaked in July at approximately $147 per barrel, the market has been in decline since - falling by more than 70% from its high to trade below $40 per barrel on an increasingly pessimistic outlook for the global economy. Given that there remains a large degree of uncertainty surrounding the economic outlook, for many the question has now become - 'how low can oil prices go?' with some commentators expecting $25 per barrel.
The sharp increase in the oil market to a price of $147 per barrel in mid-July 2008 was seen as being due to a combination of supply-demand fundamentals (notably demand from China), prevailing economic conditions (a weak US dollar meaning that oil was cheaper for consuming nations) and speculative investment in oil (as a replacement for the comparatively poor returns seen on equities and other financial commodities).
In 2009 the global oil industry is facing the first drop in annual demand since the recession of the 1980s. As such, the future for oil prices while the global economy slows down is uncertain at best, but there will be a major impact on investment and the growth of the sector. Forecasts from the International Monetary Fund (IMF) show that the global economy could remain weak until the first half of 2010, although this is itself dependent upon the speed with which banks and governments recover from the financial crisis. Against this backdrop, there is the potential for a 'double whammy' for the oil market.
Firstly, weaker economic growth implies that oil demand will fall and result in lower prices - as we have seen in the second half of 2008. This fall in prices will reduce the incentive for oil companies to invest in new plant and production and refining capacity, a prospect that has already been highlighted by the International Energy Agency (IEA). As such, marginal sources of supply will remain undeveloped as some plans become uneconomic at lower wholesale market prices, impacting the medium-term production potential of the industry.
Secondly, another factor that will limit investment in the oil sector is the availability of financing in the wake of the problems that have dogged the credit markets. Here, companies that may have relied on borrowing to fund new projects may struggle to achieve their plans, meaning that some schemes will inevitably fall by the wayside. This could notably be the case for unconventional oil developments and biofuel projects, many of which are reliant on high oil prices for their commercial viability.
There will therefore be medium and long-term implications for an oil sector that is still coming to terms with years of underinvestment - notably in the area of refining. The greater longer-term implication perhaps is what the impact on demand will be give the global economic slowdown - specifically will there be demand reduction (i.e temporary) or demand destruction (i.e permanent)?
Against this backdrop of falling prices, producers' cartel OPEC has made progressive reductions in its quote output in a bid to stabilise the market. The slump in demand led - in December 2008 - the members of OPEC to cut production to 4.2 million barrels per day against the September 2008 level which, factoring in other cuts made in the interim, meant that output will be reduced to 24.845 million barrels per day for the eleven members of the organisation. The December cut represented an additional 2.2 million barrels per day against those made in advance of the cartel's meeting.
While indicating that it would do away with its practice of practice of price targets for the time being, representatives from the cartel's largest member - Saudi Arabia - indicated that their goal was to remove the oversupply from the oil market, but described the 'fair' price of $75 per barrel as being 'for a much more noble cause' given that some marginal producers could not make money at current market rates. Likewise, speaking at the World Economic Forum in Davos, BP chief executive Tony Hayward supported OPEC's view of a higher price, stating that a price of between $60 and $80 per barrel would meet OPEC's requirements and encourage investment in the sector in the long-term. At the same event, OPEC secretary-general Abdalla el-Badri stated that a price of $70 to $90 per barrel was 'reasonable' to promote investment in new production.
OPEC continues to walk a tightrope as far as its production levels are concerned – any excessive cut could cause the market to rise sharply and potentially deepen the global economic slowdown, while not cutting enough could harm the credibility of any future statements regarding output and further weaken the market.
In terms of production levels going forward, the decision to delay investment in new fields or infrastructure – while commercially sound in the current environment – may effectively be storing up problems for the future. For example, a delay of between one and two years for new developments due to the drop in the market could lead to a renewed tightening of the supply-demand balance when the international economic outlook improves.
This will lead to upward pressure on market prices and could potentially lead once again to the type of market volatility seen in the latter half of 2007 and the first half of 2008. As such, while the outlook for the global oil market is set to remain governed by the economic outlook, it is clear that there is a risk that today's recession induced oil surplus could become tomorrow's shortage.