Ultimately, the price of oil is determined by supply and demand. What is special about the oil price is that, in theory, there are several equilibrium prices. This is because a large part of the supply is linked to a state budget. Where normally the supply goes down when the oil price goes down, there are countries that in the past pumped more oil to realise the same yield.
Knowing that the final price is determined by the marginal buyer and the marginal seller, identifying these two parties is essential for predicting the oil price.
In 2014, the oil price halved after a major transaction between the marginal buyer and the marginal seller. The marginal buyer at the time was China and the marginal seller was Russia. In February of that year, the conflict between Russia and Ukraine started. Russia did not want to be too dependent on revenues from gas and oil exports to Western Europe in view of European sanctions.
In May of that year, a deal worth USD 400 billion was struck with China. China took advantage of the situation and only had to pay half of the market price. In the following months, the energy market adapted to this new reality. For a long time, an oil price of USD 50 per barrel was a ceiling rather than a floor.
Monetary policy and innovations
Since the Great Financial Crisis, US oil production has increased from around 5 million barrels per day in 2008 to a peak of 13 million barrels per day in 2019. That is a higher production than Saudi Arabia or Russia. This has been made possible by the Federal Reserve’s monetary policy, which lowered the cost of borrowing, and by innovations such as horizontal drilling and fracking. These innovations were a direct result of the high oil price before the Great Financial Crisis.
Normally within OPEC, Saudi Arabia is the marginal seller, but the Saudis feared competition from US shale farmers and pumped as much oil as possible to frustrate the US oilmen. Given the rising US production, they did not succeed. Because of the reasonably steep learning curve, the costs of the unconventional way of oil extraction turned out to be much lower than expected. From now on, the United States was the marginal seller of oil and the power of OPEC, Saudi Arabia and Russia was broken.
Biggest cut ever
At the start of the Covid-19 crisis, OPEC & Russia cut production by 10 million barrels a day. That was the biggest reduction in oil production ever. In theory, a united cartel is capable of doubling the price of oil with a small reduction in production, but such unity is sometimes lacking. Not this time.
Meanwhile, oil production outside OPEC is under pressure. As part of the energy transition, more and more parties are demanding that oil companies stop investing in new production. Central bankers are warning commercial banks to stop lending money to oil companies because of the risk that not all the oil will be pumped out of the ground. Sustainable investors demand that oil companies use their cash flows to invest in alternative energy.
The valuation of oil companies today is much lower than energy companies that have made the transition to alternative energy, a financial incentive for the managements of oil companies to make the same transition. Otherwise, they will be stopped by a stray judge. Furthermore, last year’s extremely low oil price caused many long-term investment projects to be cancelled. The best cure for a low oil price is still a low oil price.
Lack of investment
Despite the higher oil price achieved by OPEC, production outside OPEC is hardly rising now. Production is still 2 million barrels per day lower than at the peak of 2019 when the oil price was lower. It is likely that production will even shrink in the coming years due to the lack of new investment. Meanwhile, oil demand is rising again towards 100 million barrels per day, similar to pre-Covid-19 demand. In a year’s time, oil demand is likely to exceed global potential pumping capacity. That is the first time in the 160-year history of the oil market.
It is striking how much is said about the energy transition, while it is simply not visible in the demand for oil. Due to low investments outside the OPEC area, OPEC’s market share will rise from 37 per cent today to 52 per cent in 2050. A cartel that gains power can only mean one thing: rising prices. At the beginning of this century, production in non-OPEC countries also fell, with the result that OPEC’s increased power allowed it to quadruple the price of oil from $35 a barrel to eventually $145 a barrel. After all, OPEC’s biggest competitor is non-OPEC oil.
Oil crisis looms
Because of the climate crisis and the energy transition, analysts seem convinced that the demand for oil will fall rapidly. This is not or perhaps not yet visible in the statistics. If the capacity limits are reached in a year’s time, even a new oil crisis is imminent. Even in the two oil crises of the 1970s, there was always sufficient production capacity. In the previous oil bull market that started in 1999, oil prices rose from USD 11 to USD 145.
When the participants in the oil market realise how close demand has come to the maximum supply, the slightest disruption can cause the price of oil to rise rapidly. This could be Iranian-Yemeni missiles fired at Saudi oil installations, but a cold winter could also be enough to push oil and gas prices up sharply. Then there are no more marginal sellers, only marginal buyers.
Han Dieperink is an independent investor, consultant and knowledge expert for Fondsnieuws, Investment Officer Luxembourg’s sister publication. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co. He is currently active as chief commercial officer at Auréus Asset Management.