15th September 2016

It is now two years since oil prices halved in the second half of 2014. The chart below reminds us that this fall was far less severe than the oil price collapse during the GFC, when prices recovered very quickly. Why aren’t prices beginning to recover now?

The causes of the two price falls were very different. The 2008 collapse was triggered by factors outside the oil market – specifically, the GFC’s liquidity crisis which shut down bank lending and trade finance, followed by lower demand as a result of the recession in developed countries. But when central banks pumped up liquidity, global oil demand recovered.

The 2014 collapse was caused by excess supply in the oil market itself. The combination of over-production from OPEC and new US production from fracking propelled oil inventories to record levels, despite strong global demand. Two years later, oil inventories are still very high.


It was widely assumed that, because the cash production costs of oil from fracking averaged about USD$70 per barrel, US producers would cut production, global supply would decline and the market would be back in balance. This assumption overlooked two important facts.

First, the figure of USD$70 for the average cash cost of oil from fracking was based on a period of prosperity: most new US production had been brought on stream at a time when prices were high and margins were good – that is, companies’ production systems had been gold-plated because there was no need to worry about costs. When companies felt their bankers breathing down their necks, their production engineers were able to trim cash costs by 20% or more.

The second fact is that, even though the fracking industry had been developed with debt and many US producers were over-geared, debt is attached to the company, not to the oil well. That means, when an oil company goes into Chapter 11, its production does not necessarily cease. The debt may be written down and the company reorganized, or its wells may be sold to another company which knows how to produce oil from them more cheaply.

The effect of these two facts is that US production of oil from fracking has fallen by much less than expected. For oil from fracking, OPEC estimates that current US production of 4.04 million barrels per day (m b/d) is only 12% below its 2015 level of 4.60m b/d, and that 2017 production will decline by only 12% to 3.56m b/d. In view of the fact that OPEC currently produces 32.7m b/d, the US declines are hardly significant.

Despite frequent calls for price “stabilization”, OPEC members haven’t cut production either. Nor are they likely to. The outlook for the oil market has been analysed in terms of game theory, the social costs of production, the price elasticity of oil demand, and many other variables. We prefer to answer the question by considering OPEC as a coalition of big countries and small countries.

The “big countries” group is the group of countries with large populations, such as Iran, Iraq, Nigeria, Algeria, Venezuela and Indonesia. To this group we can add Russia and China, which are the world’s third- and fourth-largest oil producers, because they have exactly the same motivation – to produce as much oil as possible. All these countries want to earn foreign exchange and maximize government revenues so that they can buy imports, subsidize their populations, and keep their rulers in comfort. Therefore, they don’t voluntarily reduce their production.

The “small countries” group is the group of countries with small populations, such as Saudi Arabia, the United Arab Emirates, Kuwait and Qatar. These countries are quite capable of cutting production because their needs are much smaller: they have fewer princes, oligarchs and other cronies to feed. They have voluntarily reduced their own production in the past, but not for long, because the revenue benefits flow mainly to the big countries who haven’t cut their production.

Let us put this in context with some figures from OPEC’s latest Monthly Oil Market Report. Global oil demand remains strong, mostly because of growth in the US, China and India. OPEC forecasts world oil consumption to rise from 93.94m b/d in 2015 to 94.27m b/d in 2016 and 95.42m b/d in 2017.

But supply is barely falling, despite the lower prices. Non-OPEC supply decreased only 1% from 56.92 million b/d in 2015 to an estimated 56.32 million b/d in 2016. OPEC forecasts that it will rise slightly to 56.52 million b/d in 2017. That is, the modest reduction in US oil from fracking is being offset by small rises in conventional production around the world.


What this chart says is that the problem is that OPEC is currently producing 32.7m b/d, but demand for OPEC oil is only 31.7m b/d at present. The surplus has to go into inventories, which are already at near-record levels of 100 days forward consumption. According to OPEC’s forecasts, the situation will improve in 2017, when demand should reach 32.5m b/d. If OPEC production does not change materially, the oil market will be back in balance about mid-2017, so oil inventories will begin to fall and prices may begin to rise.

The complication is that most of the shut-in US production can be brought back on stream within twelve months at modest cost if oil prices justify it. When oil prices fell in 2014, many companies chose not to spend money on completing their directional wells. As a consequence, there is up to 1m b/d of production from fracking which is economic at oil prices above USD$60 and can be brought on stream with some capex on well completions. Hence rising prices would be offset by rising production. It is unlikely that the oil market will be back in balance until world oil demand has risen by enough to offset this potential production increase, i.e. to at least 96.5m b/d in 2018 or later.

In summary, we believe that oil prices are about halfway through a four-year correction process. We expect oil to trade between USD$30 and USD$60 for the next two years, subject to seasonal factors. It is possible that a major supply disruption could lift prices; it is also possible that weak global growth could postpone the price recovery by a year or two.