What is the outlook for oil? For investors, getting this right may be critical, as the oil price is likely to have a profound effect on global growth and asset prices.
Crude oil prices have plunged more than 60 per cent over the past couple of years and are near their lowest level since 2003, the recent rebound notwithstanding. After taking into account inflation, crude oil is cheaper even than the lows of 1980s and 1990s.
“We may have to ride through quite a bit of volatility”
Historically, such a sharp decline in oil prices has been accompanied by a recession and a collapse in energy demand. Yet, the story of oil’s latest decline could hardly be more different.
Far from a recession, global demand for oil has been rising steadily in recent years, primarily because of soaring demand from China, India and other emerging markets.
Our base case is for oil averaging around USD45-USD55/barrel (bbl) over the next 12 to18 months. This is likely to lead to an unprecedented transfer of wealth (amounting to trillions of dollar, according to some estimates) from the world’s oil producers to oil consumers.
Since the world’s biggest economies are all net consumers of oil (US, Europe, China, Japan and most of Asia), such an outcome should be positive for global growth. However, we may have to ride through quite a bit of volatility on the way.
Blow to oil prices
The game changer this time – and the source of ongoing volatility – is the so-called ‘shale revolution’ in the US, where oil producers have employed a new horizontal drilling technology to extract vast reserves under rock formations deep below the earth’s crust. This method has been so successful that US output, after two decades of decline, has soared from around 5 million barrels per day (mbpd) in 2008 to above 9 mbpd in 2015, turning the US into the world’s largest oil producer.
However, it was the competitors’ response to this US supply shock which dealt the final blow to oil prices. Instead of accommodating the new stream of supplies, Saudi Arabia and Russia, the world’s two other leading producers, decided to maintain their output and preserve their market share.
“The global demand-supply gap could close over the next 12 to 18 months”
Where do we go from here? The medium- to long-term picture for oil is easier to construct. Most estimates point to excess global supply of about 1.0-1.5 mbpd at the end of 2015. Annual demand growth tends to average about 1 mbpd in non-recessionary years. Indeed, recent data suggests that demand from the developing world shows no signs of slowing. This means the global demand-supply gap could close over the next 12 to 18 months.
This outlook is likely to be supported by supply cutbacks by producers who are no longer viable at current prices and unable to access funding, largely in the US and Canada. We are already seeing such pressures among some of the smaller US shale oil producers. As a result of these shutdowns, US output has fallen since the peak in June 2015. However, this does not create an unambiguously bullish story for oil, as record US inventory levels still need to be burned through.
Iranian production is a wildcard, now that export sanctions against OPEC’s fourth-largest supplier has been lifted. Iran’s oil output in the short term is likely to be limited by the lack of investment over the past decade. However, we believe this factor is priced in. In the longer term, new investment in oil infrastructure could mean significant new Iranian output.
Near-term outlook is murky
The near-term outlook for prices is murkier as oil may be driven by a host of factors. These include market sentiment, valuation, investor positioning, the US dollar, technical indicators, storage capacity and geopolitics.
There is a risk prices could decline further on the back of positive surprise in supplies, notably from Russia where output continues to surge, or Iran. Similarly, a further surge in the US dollar could hurt oil prices (as the two tend to move inversely). Geopolitics could dampen prices as well – the rivalry between Saudi Arabia and Iran may lead the Saudis to keep pumping to ensure prices stay low, denying Iran a revenue boost.
“USD50/bbl oil would relieve some stress on the balance sheet of oil producers and their lenders”
In terms of a price ceiling, our base-case scenario is for oil staying below USD60-65/bbl over the medium term – any higher and marginal shale players become commercially viable once again, driving prices back down. Thus, in the next 12 to18 months, a range of USD45-USD55 seems appropriate.
Oil stabilising at these levels is likely to be a major boost for the slowing global economy. Asia’s largest economies, including China, Japan, India, South Korea and most of Southeast Asia, are among the world’s biggest oil importers; they would be directly benefitted by the ‘lower-for-longer’ oil price scenario. Meanwhile, USD50/bbl oil would relieve some stress on the balance sheet of oil producers and their lenders. Such an outcome is likely to extend the seven-year long economic expansion the world has enjoyed since the global financial crisis.