By: Niels Jensen, CIO Absolute Return Partners
The days of $100-140 oil prices are most likely over, at least for the time being, unless a new dynamic pops up on the horizon.
Several incidents in recent years have caused fundamental changes to global oil markets. I would suggest that the most important ones are, financial crisis aside, the emergence of shale oil and gas, the rise of ISIS and the Iranian nuclear conflict, which has, after years of negotiations, ended only a few days ago with what appears to be a promising agreement. So, what of these three and will we see lesser volatility in the price range?
A short while ago the world woke up to some of the most encouraging news it has seen in a long time. Iran finally agreed to what was presented to the outside world as a nuclear deal; however, we don’t think the full extent of the deal has yet been published and probably never will be. We believe there is much more to the deal than what first meets the eye.
The United States has not been most pleased with Saudi Arabia for a number of years. Saudi, which is a Sunni Muslim country, has openly supported Sunni militants in Iraq with the intention of weakening Shia dominated Iraq and Iran. In addition to that, the U.S. appears keen to downsize its presence in the Middle East, full stop. Much lower oil imports have, in the eyes of the U.S. government, made the region less important politically.
This is where a deal with Iran fits perfectly as Iran has aspirations to play a bigger role on the political stage, and it can supply the world with oil (and gas – more about this later). In fact we wouldn’t be at all surprised if Iran has been ‘granted’ a bigger role to play in Middle Eastern politics. The U.S. will step back and effectively pass the regional superpower role to Iran. This could quite possibly give Netanyahu a few sleepless nights.
Such a deal would have significant implications. As far as energy prices are concerned, there are at least two. Firstly, the ‘Hormuz Strait premium’ (i.e. the risk premium on oil prices caused by regular incidents in and around the Hormuz Strait) is likely to all but disappear. Iran is the only naval power in the region with enough firepower to cause serious problems in the Hormuz Strait, and the 17 million barrels of oil that pass through the strait every day will be able to do so at much lower risk now.
Secondly, and surprising to many people, Russia is not the biggest proprietor of natural gas reserves in the world; Iran is. Germany has, for quite some time, been looking to reduce its dependency on Russia for natural gas supplies, upon which it is very reliant. With export sanctions now lifted, Russia’s influence on European energy politics could be greatly reduced, and volatility should drop as a result.
Overall, the agreement with Iran should reduce oil price volatility meaningfully. Iran has big enough reserves that they can act as a very effective buffer in case there are supply problems elsewhere. Lower oil price volatility should also be good for overall economic activity. As far as the absolute price level is concerned, the first reaction to the deal has seen price falls of $1-2 per barrel. The longer term implications are not yet entirely clear, but we don’t expect the agreement to have a massive effect on prices in the short term, given how much prices have already fallen in the last year.
The emergence of ISIS, and the problems it is causing, is in many ways a reflection of a broader divide between Sunni and Shia Muslims. It may be premature to write off OPEC as a result, but continued terror actions and/or outright (civil) wars will do nothing to keep OPEC together. Cartels never work when members are at each other’s throat.
If ISIS had the military power to instigate more wide-ranging infrastructure damage, we would be far more concerned about the price, and volatility, of oil but, at least in the short to medium term, that is not the case. ISIS can certainly create some short term havoc, which can move oil prices modestly over a few days or weeks. Having said that, ISIS is not (yet) capable of creating the sort of oil price volatility that we have seen in recent years, i.e. 50%+ price moves over relatively short periods of time.
Should OPEC disintegrate as a result of the Sunni-Shia divide, oil prices would probably drift lower over a period of time. Prices are almost always lower when pricing is not impacted by cartels, and that would almost certainly also be the case as far as oil is concerned.
Overall, we expect ISIS to cause occasional volatility to oil prices, at least in the short term. Longer term, ISIS is a joker. Nobody has a clue how the whole situation will unfold eventually.
Shale oil and gas
The development of fracking techniques, whether shale or other, undoubtedly represents the most important development in the oil and gas industry in recent times.
U.S. domestic shale oil production is now in excess of 5 million bbl/day. If you add to that the over 4 million bbl/day which come from Canadian oil sand deposits, much of which is exported to the U.S., one can begin to understand why the U.S. now import only 2-3 million bbl/day of oil from OPEC.
Apart from improving the U.S. trade balance considerably, shale is having the important effect of putting a lid on oil prices. The shale industry is not enormously informative about production costs, etc., but it is estimated that the average U.S. shale oil producer is now capable of producing oil at $70-80 per barrel.
This level is fast becoming the top end of the trading range. Should the price of oil trade at higher levels for any meaningful period of time, shale production will simply expand until the price drops again. At present, only the U.S. has the technology to quickly ramp up production, should the price warrant it, and ramp it down again if required. However, as we have seen more recently, one country is enough to unsettle a market that has effectively been controlled by OPEC for many years.
The upshot: Oil to trade in a tighter range
All of this implies that reduced volatility is to be expected going forward. Where oil prices in recent years have traded in a range of $40-140 per barrel, one would expect that range to be considerably tighter going forward.
If one assumes that the price won’t drop below the cost of production for any meaningful period of time (as it rarely does), and one assumes that the average production cost today is not far from $50 per barrel (chart 3), then oil prices should trade in the range of $50-80 per barrel (give or take).
Obviously, terror actions by militant Muslims and other temporary supply disruptions can drive the price outside that range, but probably not for an extended period of time. The days of $100-140 oil prices are most likely over, at least for the time being, unless (until) a new dynamic pops up on the horizon.