The new mathematics of oil: How to solve the price-demand-supply equation
- Written by Prof. Constantin Cranganu, Brooklyn College of the City University of New York
On March 3, 2015 amazing news hit the US media: US oil stocks reached 444.4 million barrels, the highest amount ever stored starting from the 1930s . The previous week the stocks rose by 10.3 million barrels , the highest growth rate since 2002. The gas production in February 2015 exceeded 2,000 billion cubic meters/day , up by 1% as compared to January and up by 10.5% against the production registered in February 2014.
The fact that the United States have reached the stage as not to have where to store the oil and gas produced by US companies is the most brilliant and unexpected confirmation of the technological revolution’s success called hydraulic fracturing of oil shales and gas shales. At the same time, for many, the motto may sound like a contradiction in terms: as the United States were, until recently, the largest hydrocarbons consumer, (some ‘script-writers’ even said that the war in Iraq was, in fact, started so that the Americans could seize the oil there!?!), now, the United States now have too much oil and gas!!! The international markets and the financial world were forced to accept this new paradigm. Thus, this has led to a reassessment of the strategies on production, refining, storage, sale-buy, etc., on the short and medium term.
Oil markets continue to oscillate between an acute state of anxiety and a fragile sense of hope that the adjustment of supply, expected by many, is already on the way. I believe this adjustment, when it will occur, is going to change the fundamental structure of the oil markets and we are going to witness, in the next five years, the emergence of a new mathematics of oil, in which the classical equation of price-demand-supply will require multiple solutions in order to get solved. In the article ‘Oil deflation. Causes and Consequences ’ I pointed to three events as being the triggers of the current deflationary environment (the hydraulic fracturing revolution in the US for shale oil clays, the restart of production in Libya and ‘the OPEC gambit’ on November 27, 2014). But the beginning of 2015 brought to the forefront a new issue, which I believe will substantially affect the oil supply adjustment seen as a possible way to solve the price-demand-supply equation: the United States’ turning into a swing producer (i). By accepting this new role for the US, the OPEC strategy, controlled by Saudi Arabia, creates an environment with high price volatility and significant stress on capital markets and financial mechanisms. Moreover, discussions are taking place about the disappearance of OPEC’s role as arbiter on the world oil markets (Why OPEC is dead ).
The crucial question for this beginning of the year: is it proper for the United States to play their new role as swing producer and to adjust their offer in order to stabilize/increase the oil prices? Let’s see, firstly, how the three terms of the equation are working currently, at least for the next five-year term 2015-2020.
Due to the revolution brought by the hydraulic fracturing, shale oil producers in the US have become unintentionally swing producers. This means that the pace of adding new offers on the market will rapidly adjust in response to oil price changes. Or, in other words, it is expected that the United States’ oil production sees its growth rate cut during 2015-2017 in order to get relaunched in response to a narrower market. Therefore it is estimated a moderate increase in production during 2015-2017 (from ~ 9.5 to ~ 10.4 million barrels/day), which will be followed during 2017-2020 by increased production of up to 13 million barrels/day. In 2014, the contribution of shale oil to the US total production was of 1.5 million barrels/day, the highest annual growth in US history (ii).
Imposing or rather, the taking over by the United States of the new role of swing producer in the oil field was determined by the OPEC’s change in strategy, specifically Saudi Arabia’s decision in November 2014 to make a decisive move: it abandoned after four decades the control of oil prices by increasing/decreasing production. Practically, OPEC has allowed the free markets to decide the price of oil, even at the risk of flooding them with overproduction.
In the new five-year term (2015-2020), OPEC will continue to exist, but not as we knew it. Saudi Arabia will continue to defend its market share, but at the same time it will allow the free market to operate. The oil markets will struggle to find a new price strand for balance. In this context, price changes are possible with high frequency, since consensus on the stock market is very unstable by its nature.
Playing the role of swing producer instead of Saudi Arabia will be a challenge for the United States. Currently, the shale oil produced by the US has imposed this role, but periods dominated by investment means that changes in oil production will be slower than the implementing of changes in Saudi policy on production. Saudi Arabia and OPEC might attempt again to regain their status of last year. But a reheated soup doesn’t taste the same. Some OPEC members (Venezuela, Nigeria) are exhausted ‘powers’ in terms of oil because of war, internal conflicts, economic problems and lack of investments. Saudi Arabia can hope to gain a strong influence, but not as high as before.
The castling Saudi Arabia-USA has already taken place on the refined petroleum products market: in 2014, the United States exported on average 3.8 million barrels/day, an increase of 347,000 barrels/day against 2013, according to the data reported by the US Energy Information Administration (Petroleum Supply Monthly ). Exports refer mainly to petrol for engines, propane and butane, and the main beneficiaries were South and Central America, Canada and Mexico. The US exports of refined petroleum products in 2014 have increased for the 13th consecutive year. At the same time, Saudi Arabia exported 2.3 million barrels/day of refined products and it was pleased to take the second place on this market .
Along with the United States and OPEC, which changed roles earlier this year, other players on the market of oil supply should be considered in the immediate future:
Iraq - security is appropriate to increase production, especially in the south, but higher insecurity in the rest of the country creates risks.
Iran - a comprehensive and stable nuclear agreement proves to be illusory, but oil production continues to grow slowly.
Gulf countries -they succeed to maintain production, in the absence of regional unrest, but problems can show up quickly.
Venezuela - production is declining and there are risks of political change.
Russia - the tensions incurred by the Ukrainian conflict have cut its access to capital markets and to technology; accordingly, the productivity is on the decrease.
Late shocks from postponed or cancelled projects will diminish the offers coming from well known areas such as West Africa or the North Sea. There will be surprises, including from unexpected places.
The chart 1 illustrates the forecasted production changes of the 12 OPEC members during 2014-2020.
Except for the US, the oil production of non-OPEC countries will remain constant, instead of being on the increase.
Tip for solving the equation: supply adjustment is needed immediately to rebalance the oil market.
At first glance, the oil demand growth shows an upward trend. In 2014 the demand has increased only by 0.6 million barrels/day, but in 2015 it is expected to reach up to 1 million barrels/day and 1.3 to 1.4 million barrels/day during 2017 - 2020.
On regional level, however, the demand could be weaker (e.g. in Russia/CIS and Latin America), which will reduce the effect of demand increases in the US and on other markets. The improving economic conditions are the key factor for oil demand growth. The reply to the demand is a function of two variables: price elasticity (iii) and the increase/decrease of the GDP, which are unique to each country.
The IHS analysts (www.ihs.com) estimate that by 2020 the oil demand growth will approach 1.3-1.4 million barrels/day, mainly due to improved economic conditions (see the chart 2).
Emerging markets (e.g. China, India) will continue to drive the growth demand, while European countries will have a partial contribution, sometimes negative. As shown in the chart above, the countries of the Asia-Pacific area will contribute the most to the overall demand growth, particularly for liquid hydrocarbons.
If the gasoline demand on the free market responds to the falling prices, demand for diesel is mainly controlled by the GDP. Thus, in 2015, diesel is half the demand, including changes in fuel specifications used by oil tankers and other ships for ocean transport.
Tip for solving the equation: it is very likely that during the next five years, the increasing demand will not ‘swallow’ the excess supply, in other words the demand is not the solution to surplus production.
The global oil balance, price outlook and alternative scenarios
The global balance for liquid hydrocarbons rebalances only as supply growth will slow after 2015. In this dynamic relationship, two phases are foreseen:
• Phase I: 2015-2016. Oil prices will remain under pressure until the production excess is cut or is eliminated. Most offer adjustments will take place in the United States. Brent oil price will reach USD 47/barrel in 2015 and USD 63/barrel in 2016.
• Phase II: 2017-2020. Prices will go up enough to stimulate production development that would meet aggregate demand growth of 5.5 million barrels/day during 2017-2020. The projects postponed from 2015-2016, in particular the deep water areas ones, will have a definite impact on supply. Prices will have to stimulate also the US onshore production in order to meet the demand. Brent oil price is expected to reach USD 70-95/barrel.
There is no secret that the current US law does not allow the export of crude oil. So US producers can sell it only in the US at a price called WTI index (West Texas Intermediate) on the NYMEX market (New York Mercantile Exchange).
Historically speaking, the price differences between Brent (London international market) and WTI index were insignificant as long as the United States were the largest importer of oil. But since 2008, hydraulic fracturing of the oil from shale formations (mainly Bakken, Three Forks, Eagle Ford and those in the West Permian Basin) have radically changed the structure of US imports. As I wrote above, currently the US don’t have any more space to store the excess oil.
The traditional spot to store the American oil is in Cushing, Oklahoma, the city that delivers quotations to New York which are to be included in the WTI price. The storage capacity at Cushing is 71 million barrels and is close to the upper limit.
Differences in price between Brent and WTI (see the chart below) have increased steadily since 2012, reaching USD 12.78/barrel currently. Financial analysts estimate that these differences could even reach USD 15-20/barrel in the coming years as long as the US producers will not be allowed to sell on the international market, where the Brent price is set.
No wonder, therefore that in the current situation dominated by overproduction, lack of storage space and low prices, two particular aspects of the American oil industry have surfaced:
- Part of the production went into contango: oil is stored in oil super-tanks, with capacities up to 4,000,000 barrels – Romania’s consumption for 19 days!! – in expectation of price adjustment.
- Mounting pressure to lift the ban for the US crude oil exports is seen , because the low WTI price does not favour domestic producers. They feel being wronged they cannot sell at Brent prices, much higher currently.
Using energy scenarios as a key element for strategic differentiation
Scenarios are powerful tools that help companies to plan for the future, whether it’s all about the next year’s budget growth, about the development of a new strategy, a strategy revival or the test for an investment decision. In all these cases, the use of scenarios can be very useful, as scenarios extend analysis beyond a simple linear characteristic in the future.
When we are surprised by developments occurring in the future, it’s often due to lack of imagination. By using scenarios, we can look to the future with more lenses instead of one. We develop two or three perspectives of the future, very different views to test our assumptions and prejudices. By using scenarios we are forced to be explicit about what we assume regarding the future and to consider alternative outcomes. In addition, scenarios are a very effective instrument in time for testing the strategies and for increasing companies’ resilience when facing adverse events and also for more efficient implementation of the benefits coming from the new emerging opportunities.
Scenarios on rivalry, autonomy and vertigo
The IHS analysts created last year a new generation of global energy scenarios. ‘Rivalry’ is how they call the planning scenario or the reference case. Rivalry is a world of growing competition between energy sources: renewable, oil, natural gas and others. This rivalry is manifested in several ways: natural gas will begin to enter the transport market; electricity will play a more significant in transportation, etc.
For example, today there are about 900 million cars worldwide. In 2040 their number will double, will be about 1.8 billion. However, demand for petrol will not increase as much, as many of these cars will be more efficient than they are today, many of them will use natural gas and some will use electricity. This is a possible example of energy rivalry in a not too distant future.
There are two alternative scenarios. One is called ‘autonomy’ (see the chart above) (iv). Autonomy is a fascinating world where local demand is satisfied to a high degree by local energy sources. In other words, renewable energies become more efficient in terms of costs. But on the other hand, this will mean a greater expansion of the unconventional oil and gas production. Thus, there is much more energy supply in many parts of the world which today do not have sufficient energy production.
The second alternative scenario is called ‘vertigo’. Vertigo means a world of accelerated technological changes. It is a world where self-driven cars become widespread. It is a world where computers play a much more significant role in medical diagnostics, for example. It is a world of great technological changes, but also a world where changes are so huge that it is very difficult for governments and for human societies to keep the pace with these changes. And this has a great impact on energy. Disagreements surface between the energy demand and the energy supply. In other words, vertigo means a world of great changes, very fascinating and very turbulent at the same time.
What should be noted, for the three scenarios proposed by the IHS, is the price change of the Brent crude oil barrel during 2015-2020:
- Scenario ‘autonomy’ forecasts an almost constant price at around USD 60/barrel;
- Scenario ‘rivalry’ is based on a price below USD 50/barrel in 2015 and considers a price of USD 90/barrel in 2020, while
- Scenario ‘vertigo’ suggests a W type price evolution: down from 2014 in 2015 to USD70/barrel, up in 2018 to USD 130/barrel, then down again in 2019 and in 2020 to USD 80/barrel.
The final indication for solving the price-demand-supply equation: Use all of the above.
i) Swing producer refers to a supplier or a limited group of oligopoly suppliers for a commodity, which control the deposits and have high production capabilities of that commodity. A swing producer is able to increase or decrease the supply of goods with minimum additional costs and thus is able to influence the prices and to balance the markets, offering short and medium term protection against the negative features of investment. Classic examples of swing producers include Saudi Arabia for oil (until this year!), Russia for potassium fertilizers or the company De Beers for diamonds.
ii) BP Energy Outlook 2035 http://www.bp.com/en/global/corporate/about-bp/energy-economics/energy-outlook.html
iii) An explanation of the concept of oil price elasticity can be read here: http://faculty.winthrop.edu/stonebrakerr/book/oilprices.htm
iv) The prices are nominal, reflecting the oil value in different years. Actual prices (not shown in the chart) are adjusted in accordance with differences in price levels for the years considered.