Thoughts on Crude Oil Price Projections for 2016

Oil & Gas
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Monday, February 8, 2016 07.14 PM/First Bank
 

The end-to-trough cycle of falling crude oil prices that began in mid-2014 is not in sight. Already, crude oil prices have dropped below $30 per barrel ― lower than the nadir reached during the 2008/2009 Great Recession; and there are projections that the prices may nudge $20 (as forecast by Goldman Sachs, Morgan Stanley, and International Monetary Fund), or even $10 (in Standard Chartered Bank’s most recent estimates).


 

Much of the conversation on the back of these bearish forecasts has centred around the feasibility of this oil price trajectory. Put differently, the unanswered question, today, is by how much the oil price outlook has diverged from market fundamentals? To answer this question, it is important to consider the costs of oil production in key oil producing and exporting countries.

 

At $20 per barrel, crude oil production is profitable in only six countries (Kuwait, Saudi Arabia, Iraq, United Arab Emirates, Iran, and Russia). The cumulative oil production per day in these countries is 35.46 million barrels per day (mbpd). This is less than two-fifths of the global crude oil demand forecast (94.17mbpd) in 2016.
 

But if we disaggregate the cost elements to capital and operational expenditure, and assume that all the countries whose operational cost is less than $20 will continue to produce oil, then the number of countries in this category will increase from six to 17.
 

The total oil production in the 17 countries will be 70.57 million barrels per day. Again, this is less than (about 23.6 million barrels below) the 94.17 million barrels per day crude oil demand outlook for 2016.
 


 

Similarly, a comparative analysis of the growth rates of the largest consumers of crude oil in the last two years and the projection for 2016 shows that there is no significant difference between the patterns of growth. In fact, the world economy is projected to grow by 3.4% in 2016 (up from 3.1% in 2015) — buoyed by stronger growth expectations in advanced economies, and emerging market and developing economies.
 

Thus, the crude oil demand in 2016 should not be less than the estimated crude oil demand in 2015, and the expected increase in Iran’s crude oil production will be insufficient to bridge the 23.6 million barrels daily demand gap. What these then suggest is that the $20 crude oil price forecast for 2016 is not supported by strong fundamentals.
 

What then is the driving force behind the gloomy oil price projection? It is a combination of several factors, including oil production market share game, behavioural response to oil price trend, and asset pricing considerations. Of these, the factor with the most influence on the downward oil price trend is the oil production market share game.
 

High oil prices encourage investment in alternative energy. At $75 per barrel, the majority of shale oil production becomes profitable. So, during the oil boom era, investment in shale oil production increased.
 

And in a move to halt shale oil production, Saudi Arabia (the largest oil producer among the Organisation of the Petroleum Exporting Countries – OPEC), in 2014, began to play the oil production market share game. Shortly after the country started playing the game and its refusal to rescind its decision, OPEC allowed other member countries to produce as much as they could. This essentially ended OPEC’s quota system. The end result of this, of course, is the current oil supply glut.
 

But how long can this situation persist? While it is true that oil price may not reach $100 per barrel in the foreseeable future, the probability that OPEC and leading non-OPEC oil producing countries may strike a deal to reduce oil supply is higher.
 

Already, news that Russia and OPEC have started discussions is pushing up oil prices. If history is any guide, then this may happen soon. It would be recalled that in the late 1990s when oil price fell below $20 per barrel, OPEC engaged in a series of oil production cuts. This pushed the oil price up till the price crossed the $100 per barrel mark, and remained at that threshold until mid-2014.
 

Until then, the persistent decline in crude oil prices will continue to impact negatively on the domestic economy. The rate of economic growth has dropped, even as the inflation rate and the pressure on the naira exchange rate have increased. This is not surprising, though, given the share of oil revenue in aggregate government’s income (nearly 70%), and the proportion of oil exports earnings to total exports income (over 90%).
 

Given that Nigeria had a tough macroeconomic environment in 2015 when average crude oil price per barrel (Bonny Light blend) was $52.95, what then will be the degree of the country’s macroeconomic challenge in 2016 with the oil price trending towards $20 per barrel? The answer is obvious. So, more than ever before, managing Nigeria’s economy requires sound understanding of the macroeconomic dynamics and the political will to make tough decisions.
 

Central to this are well calibrated reforms that can facilitate the diversification of the domestic economy from the oil and gas sector. Invariably, the case for diversifying the domestic economy is often made in terms of the need to boost sources of foreign exchange earnings. However, there is a growing need to meet legitimate domestic consumption needs.
 

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