A Case against a Quick Oil Price Rebound
- US shale output will continue to increase for the short term
- Iran sanctions likely won't be lifted for months to come
- Russia may increase its production
- High interest rates have a tendency to lower the price
This article originally appeared at Seeking Alpha
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- The production of U.S. shale oil drillers will increase until next year.
- The sanctions against Iran may be lifted in a only few months.
- Some countries may have to increase their oil production because of the low oil prices.
- Higher interest rates have a tendency to lower the oil price.
- For these reasons it is likely that the oil price will stay low for a while and not rebound quickly.
"In one year, oil prices will definitely be back at levels around [insert desired amount here] dollars," these people assert.
It is understandable that after a sharp slump many investors would like to believe that the oil price has to rebound quickly. But it is always dangerous to take a possibility for a certainty. Many predictions of higher oil prices in the near future overlook critical points that could cause the oil price to stay low for notably longer than a year.
In principle there are two reasons why a price declines: the demand is too soft or the supply is too big. It seems that both of these factors influence the oil price simultaneously right now. The demand is lower than anticipated because the economies of the BRIC and the European countries are stalling.
And the supply is very high because of a lot of new oil from the US shale drillers. But the general opinion seems to be that the actual slump is more attributable to an excess supply. So I will address only the supply side in this article.
There are predictions that seem very easy. When someone predicts that the oil price will be significantly higher in 2040 than in 2014 he normally doesn't worry about being wrong. But even this simple prediction has to be treated with caution. As long as someone is talking about the nominal price of oil, the statement is almost certainly true. OPEC expects that by 2025 the nominal price will have hit $124, rising steadily to $177 by 2040.
However, predictions of oil prices far above $100 are not correct when you look at real or inflation-adjusted prices and OPEC is right with its projection. OPEC predicts that in real terms the price will be at $95 by 2020 and hit $102 by 2040. This means that even in the long run the oil price will stay below the level it had last summer.
Most forecasts are not about long-term developments, but short- and medium-term forecasts that predict a certain level of oil prices for one or two years. In such a short time, the long-term trend can be distorted by short-term developments. Even if you are right with your assessment of the oil industry, it is virtually impossible to predict the timing of a development. This makes it extremely difficult to predict the price of oil.
In addition, most predictions of a quick oil price rebound don't take into account carefully enough the following four factors:
- The response of the US shale gas industry to low prices
- The possible suspension or removal of sanctions against Iran
- The weakness of OPEC
- Rising interest rates and their impact on the oil supply
1. The response of the US shale gas industry to low prices
US oil production has increased remarkably in the last few years. This increase is almost entirely due to the shale oil deposits and their exploitation. The production of this oil is expensive, much more expensive than the production of conventional oil.
As evidence that a cutback is coming soon it is often referred to reports like this one showing that oil or gas well permits have declined significantly. But most of these considerations don't take into account central aspects in relation to the shale-oil production.
First of all, many observers confuse a decrease in the growth rate of well permits issued with a decrease in production. However, when the growth rate declines that doesn't mean that the production declines, too. Normally this means only that there will be growth but not as strong as in the previous period.
That is even more true for the shale oil industry. Because of technological progress shale drillers can produce a certain quantity of oil with fewer wells. So it's not correct to equate fewer wells with lower production.
But even when there was no technological progress, it would be wrong to assume a linear relationship between wells and production volume. Because the canceled projects are those with the lowest yields and production outputs, a decline in the number of wells results only in a disproportionate reduction of the production volume.
So production may not decline as quickly as some people assume. In addition to that, many shale companies have a lot of projects in the pipeline that are simply too far advanced to be stoppable.
Continental Resources (NYSE:CLR), a leading shale producer, plans to reduce its 2015 budget for drilling and developing sites by 12 percent. But even with these cutbacks, Continental's 2015 output will probably rise as much as 29 percent.
And even under a shrunken capital program ConocoPhillips (NYSE:COP) expects output growth of up to 5% next year. That is why many experts say that the oversupply not only will continue but will increase until mid-2015. Other experts even predict that a significant cutback of the US oil supply will not show up until 2016.
There is another complication that could delay a meaningful decrease of the US oil supply and thereby a rebound of the oil price. Many shale drillers have hedged the price of their production for a year.
2. Possible suspension or removal of sanctions against Iran
The oil price can not be explained by economic considerations only. Politics plays often an important role, especially in the case of Iran. Therefore, oil price forecasts that don't take into account the possible suspension or removal of sanctions against Iran should not be taken seriously. And it doesn't suffice to say that the sanctions will persist without a deeper analysis.
The negotiations that could lead to the removal of the sanctions are about a deal that effectively addresses proliferation concerns of the EU3+3 (that is, Germany, France, the United Kingdom, Russia, China, and the United States) over Iran's nuclear program, while respecting legitimate Iranian interests.
The details of a possible agreement are very complicated. That's why a deadline which expired last month was extended until next year. This extension shows that the negotiating parties still believe there can be an agreement.
Probably since the start of this month the EU3+3 and Iran meet at lower political levels for technical talks. This means that the negotiating parties try to draft the parameters of a final deal, which should be achieved within four months. The remaining months until a deadline in summer are to be used to complete technical annexes.
If this schedule is realized the sanctions against Iran could be lifted earlier than many people anticipated. Bijan Zanganeh, the Iranian oil minister, has already announced that Iran will double its oil exports within two months if sanctions against it end.
I admit that it is still not sure whether the sanctions against Iran will end actually. But chances are intact, and both Iran and the United States have a very strong interest to successfully conclude a binding contract. When there is no deal the consequences for both parties are dangerous and expensive.
For the USA it's not only about normalizing relationships with an important player in the middle east, it's also about stabilizing an unsettled region and maybe establishing a stronger coalition in the fight against ISIS. For Iran it's not only about regaining economic freedom of action, it's about establishing itself as a local countervailing force against Saudi Arabia.
These vital interests of both the USA and Iran make a deal much more likely. And such a deal would result in more Iranian oil coming onto the markets.
3. The weakness of OPEC
OPEC is widely regarded as weak, too weak to enforce a meaningful cutback in the oil supply. Big oil producers such as Russia and Kazakhstan, both of whom are not members of OPEC, have refused to support OPEC with an output reduction. Russia is severely hit by sanctions imposed because of the Ukraine crisis. In addition Russia suffers from a collapsing currency.
It is quite possible that the Russian state tries to compensate the mentioned adverse economic developments by expanding oil production. This could result in the paradoxical situation that in Russia it is exactly the low oil price in combination with the weakness of the ruble that necessitates an increase in oil production.
In addition it could be that in 2016 the giant Kashagan oil field in Kazakhstan will resume production. Total (NYSE:TOT), along with partners Exxon Mobile (NYSE:XOM), Eni (NYSE:ENI) and Royal Dutch Shell (NYSE:RDS.A) stopped production in October 2013 because of a gas leak.
While you could think that low oil prices will lead to a delay in the start date, this seems to be wrong. "Lower oil prices won't change Total's strategy", said Arnaud Breuillac, Total's president of exploration and production. OPEC has no influence on both the development in Russia and the development in Kazakhstan.
The weakness of OPEC could become apparent even in the relationship among the member countries. Venezuela complained that not curbing oil production is against the interests of some members. It seems possible that in Venezuela the domestic political pressure forces the government to increase the oil production to boost state revenue.
In doing this the government could compensate to some extent the revenue loss because of low oil prices so it wouldn't have to cut back important expenses like social programs.
Venezuela - and other countries - need a high oil price to balance their budget. It doesn't seem implausible that the domestic pressure could force some countries to no longer maintain the OPEC production quotas and in doing so contribute to sustained low oil prices.
4. Rising interest rates and their impact on the oil supply
Many experts assume that the Fed will raise interest rates next year. Rising interest rates are not very often mentioned in regard to oil production, even though they may affect the price of oil. Rising interest rates have a double effect. On the one hand, they shift the demand curve to the left, which leads to lower prices.
On the other hand, they shift the supply curve of oil to the right. This corresponds to an increase in volume, which also leads to lower prices. Thus, both effects result in lower prices; the effects are cumulative. But how exactly do higher interest rates lower prices?
For the demand side, suppose the long-term interest rate is 3 percent. This means for a company that an investment must have a return of at least 3 percent. If you assume an investment financed with debt capital and a yield less than 3 percent, it would result in a loss. Now, if interest rates rise to 5 percent, the required return increases also to 5 percent.
This is a higher hurdle to achieve than a return of only 3 percent. That is why when the interest rate increases there is less demand because there are less profitable investment projects than before the increase. This mechanism is also valid for the oil demand. When the interest rates increase, the demand for oil is weaker and the price will be lower.
The mechanism for the supply side is a little different. When interest rates increase, the time preference of the oil producers shifts towards the present. This will lead to an increase in production and thus lower prices.
A brief explanation: Suppose the long-term interest rate is 0 percent. As long as there is no interest, an oil producer has no opportunity costs if he defers production.
That is not the case when the interest rate rises to 5 percent. If the oil is produced now, an oil company can put the proceeds on a bank account and collect interest of 5 percent. If it delays the production, it doesn't earn these additional 5 percent, so it has opportunity costs. It is therefore advantageous to produce the oil as soon as possible.
Higher interest rates will therefore tend to increase the produced oil volume and thus lower oil prices. How large these effects are is difficult to quantify. But that does not mean you should ignore these effects.
You can not exclude the possibility that the oil price will rise soon, but there are sound reasons why the oil price will stay low for quite a while:
- The production of US shale oil drillers will increase until next year
- It's not improbable that sanctions against Iran are lifted in a only few months
- Russia may increase its oil production and domestic political pressure may force some OPEC countries to violate the production quotas
- Higher interest rates have a tendency to lower the oil price
One of the best arguments to show that it is impossible to predict the price of oil is the following plausibility consideration: if it was certain that the price of oil is higher in a year, some smart investors would buy now to pocket this money. In doing so they would drive up the price.
For example, when it was certain that the oil price will be at $80 in 12 months smart investors would buy so much that the price would immediately rise to this level. That the actual oil price is not at $80 is evidence that it is far from certain whether the oil price will be higher in a year.
That the oil price is low now means therefore that the most powerful, most experienced and best-informed players are not sure whether the oil price will rise any time soon. And when these big players are not sure, other investors should be very careful, too.
I'm not saying that you mustn't bet on higher oil prices. But you have to be clear that in this case you are not investing but speculating. Because nobody can know for sure where the oil price will be in the next 12 or 24 months. However, it seems more plausible right now that the oil price will stay low for a while and not rebound quickly.
So for the most part of your portfolio I recommend to position yourself in a way that you can withstand a long period of low oil prices.
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