Article Share – The Great Oil Debate

From the Wall Street Journal:

Where Are Oil Prices Headed? Two Experts Make Their Conflicting Cases

Phil Verleger Jr. sees prices ending the year in the $45-$50 range. Paul Horsnell predicts $75-$80.

High U.S. output is keeping railroads busy and  fueling an inventory buildup that could pull prices down.

High U.S. output is keeping railroads busy and fueling an inventory buildup that could pull prices down. Photo: MCT via Getty Images

For much of the past year, oil prices were headed in one direction: down. With output swelling from the shale-oil boom, the U.S. benchmark fell 59% from its 2014 high last June to its low on March 17.

But then came a sudden reversal. Amid concerns about the impact of low prices on supply, oil prices in April posted their biggest monthly gains in about six years.

So, where are oil prices headed next?

A lot is riding on the answer. Oil prices have a profound impact on everything from the health of the global economy to international relations, from the fate of energy companies to the pocketbooks of individuals.

Cheap oil, for instance, has been a boon to consumers around the world, but sustained low prices threaten the stability of large oil-producing nations such as Russia and Venezuela. Continued low prices could stop the U.S. shale-oil drilling boom in its tracks. A sharp rebound to higher prices, meanwhile, could shock consumers and slow already-faltering global growth.

The recent volatility in oil prices has made it especially difficult for companies, governments and even drivers to plan budgets or make reliable forecasts.

Analysts agree that the market is oversupplied, and the amount of crude oil in storage has soared. At the same time, oil producers have already announced cuts to capital spending and pulled back on new drilling.

But there is no consensus about tomorrow’s prices. In fact, far from it. Some analysts believe that the global benchmark Brent crude will rise by $15 or more a barrel by year-end from about $68 today, while the U.S. benchmark, known as West Texas Intermediate, will rise the same amount from about $60 today. Others predict that Brent and WTI will end the year below current prices.

How can the predictions be so far apart? What are the different factors that are leading to such a disparity? To better understand the debate, we asked Phil Verleger Jr., an energy economist and consultant, and Paul Horsnell, head of commodities research at Standard Chartered PLC, to explain their vastly differing predictions for oil prices. What follows is an edited version of that conversation.

Eye on inventories

WSJ: Where do you expect oil prices to end the year, and why?

MR. VERLEGER: I think Brent will probably end the year around $50 a barrel and West Texas Intermediate about $5 below Brent.

I have such a view because I see global inventories growing continually to record levels, and inventories are the most important real determinant of prices in the short run. When inventories are very high, we have seen very low prices in the past. The elephant in the room today is just this continual growth of stockpiles—most forecasts show a global buildup in stocks of around two million barrels a day this quarter and next—most of which is occurring right now in the U.S. What happens when the people holding all these inventories decide they want to sell them? All this does is prolong low-price oil for a long time to come.

MR. HORSNELL: Inventories are very much a second-quarter phenomenon, rather than something that carries on much beyond that. It will sort itself out, primarily because of seasonal increases in demand, but there will also be some falls in supply—the U.S. Energy Information Administration has recorded drops in U.S. crude-oil production and expects shale-oil output to fall heavily in May. Demand tends to be at a maximum in the third quarter, particularly demand in power generation for air-conditioning in emerging markets. That will take supply back into balance with demand, and then into deficit in the second half.

So we see Brent pushing above $80 as we get into the second half of the year, and WTI $6 to $8 lower than Brent.

Idle drilling rigs in a storage yard in Odessa, Texas, could signal a drop in U.S. oil production that would be bullish for prices.
Idle drilling rigs in a storage yard in Odessa, Texas, could signal a drop in U.S. oil production that would be bullish for prices. Photo: Dan Molinski

MR. VERLEGER: I see demand rising some with economic growth, but overall I expect relatively low growth in oil consumption this year. Europe may encounter problems as the year progresses, in large part due to Greece. There’s also talk about China slowing down. China accounted for much of the growth in oil consumption over the last five years.

Global crude stockpiles must decline before we can get prices back up to $70. I don’t see a stock decline, probably in the next 12 months.

MR. HORSNELL: Demand from China has been stronger this year than last year so far, and the Europe numbers also are more encouraging.

The EIA and the International Energy Agency both expect a far more limited fall in European demand this year.

The shale question

WSJ: Most market watchers say the oil-price plunge in 2014 was supply-driven, especially due to rapidly rising shale-oil production in the U.S. The number of rigs drilling for oil in the U.S. has now fallen to its lowest level since 2010 as companies have cut spending on new drilling. How quickly will production fall in response to low prices?

MR. VERLEGER: There is going to be almost no impact on shale-oil production. I think that oil production from shale will follow the model observed in natural gas. Several years ago, natural-gas drillers warned that the fall in natural-gas prices would quickly lead to a decline in natural-gas output. Drilling declined, but output kept rising because productivity increased so fast. I believe we may see the same in oil.

There have been new breakthroughs in productivity, bringing costs down, and we’re getting more oil from existing shale formations. History says the productivity will exceed the falloff in drilling.

I look at U.S. production continuing to increase at a relatively slow rate every month for the rest of the year. There’s so much more oil going into inventories, and prices tend to fall when supply exceeds demand

MR. HORSNELL: The difference between shale gas and shale oil is that output from a shale-oil well declines much faster than from a shale-gas well. Output from a shale-oil well, on average, falls by about two-thirds over its first year. A large amount of drilling is necessary just to keep oil output the same. In May, the new-well production will no longer be able to keep pace with the declines in production from existing wells.

Unless prices rise and drilling starts to recover, U.S. output is going to keep falling. Productivity gains can never be large enough to compensate for a halving of the rig count in five months, and that is why output has started to fall.

At these prices, [producers outside the Organization of the Petroleum Exporting Countries are] just having an awful time. I wouldn’t be surprised to see some fairly heavy falls coming in from non-OPEC production in the back half of this year and next year. Outside of North America, non-OPEC production fell in 2011, 2012 and 2013, and then managed modest growth in 2014.

The Saudi factor

WSJ: Few market watchers predicted last year’s oil-price plunge. When prices started dropping because the market was oversupplied, many expected Saudi Arabia to cut production to keep prices high, as it has done in the past. But Saudi Arabia has maintained and even increased its output. Some market watchers say the kingdom is focused on not losing market share to U.S. shale-oil producers. What surprised you about 2014, and what did you get wrong?

MR. HORSNELL: I think the big surprise was the one that, actually, we couldn’t see at the time of the OPEC meeting—the really sharp acceleration of the rate of growth in U.S. shale-oil production right at the end of the year, which we’re still getting data on. The rate of growth increased due to a rise in drilling plus productivity gains.

I think the more we look at what the numbers really were, compared with what we thought they were, the [bigger the global glut of oil] looks. But that is all gone now, and the outlook for U.S. crude output is very bleak this year. The rig count in shale areas would have to increase by around 200 rigs just to stop output from falling, and after weeks of reductions in drilling, it doesn’t look likely to start going up in the near future.

[Another] surprise was that Saudi Arabia didn’t attempt to defend the price even for a little bit. Saudi Arabia had clearly been doing a lot of due diligence on the economics of U.S. shale oil. I think the Saudi strategy is best expressed as rebalancing the market in a way that doesn’t leave the onus of [cutting production] solely on them.

With shale-oil output likely to fall off a cliff unless prices rise further and quickly, with global demand very strong and with some severe reductions in conventional non-OPEC output due in 2016, 2017 and 2018, the strategy seems to have worked. In other words, demand has been stoked and supply has been slain.

MR. VERLEGER: I wasn’t surprised after August. When the Saudis announced their prices for September crude, it was clear to me that they were beginning to start a major defense of their market share.

I think it isn’t just the fracking [that threatens Saudi Arabia]. It’s the fact that global warming is coming to the fore. [Saudi Arabia is] looking at this thing saying, “Oh dear, we probably need to change expectations as to where prices are going longer-term. We probably need to get expectations down to a $70- or $80-a-barrel level,” rather than $120 or $140, to preserve the market for oil and to make it much more expensive to those seeking to displace oil with alternatives.

It’s an extremely sophisticated and well-executed strategy. The country’s policy makers are more worried about demand peaking and then collapsing than supply peaking. They seem to see the lower prices that have followed the November meeting as a measure of insurance that guarantees the world’s appetite for oil remains strong well into the second half of the century. Today, Saudi Arabia is leading an effort to fill all the world’s tanks. Historically there is an inverse relationship between the price of commodities and inventories. Prices will fall as stockpiles rise—unless there is an agreement to reduce global production.

A known unknown

WSJ: Let’s look further ahead. Where are oil prices headed in the next five or 10 years?

MR. HORSNELL: Even with further attempts to reduce costs, etc., a lot of [crude-oil production] is actually getting more expensive rather than cheaper. For us that means still looking at prices in the $90-$100 range as being the kind of prices that you need to incentivize those supplies.

Even with shale in the U.S., it could potentially get harder. You’ve got technical improvements and efficiencies, but on the other hand, it’s an industry that has needed and thrived on cheap credit, and credit isn’t going to be cheap for the next 10 years. The credit rating of shale-oil producers has suffered with lower prices. In addition, there is a strong market expectation that the Fed will start to increase rates this year.

In our base case, we wouldn’t be expecting a disruptive change either from renewables or from the further spread of shale.

MR. VERLEGER: We have presumed that as the rest of the world economy emerges and grows, we’ll see a lot more oil used. Well, the telephone people also used to think that there would be a lot of copper wire stretched in these places, and it’s all cellular phones.

[Future oil demand] is a known unknown. We don’t know whether global warming will accelerate and the world leaders will say we have to cut fossil-fuel consumption. We don’t know what new technology is out there.

We’re going to see less development of oil because all the indebted companies, particularly the big companies, are going to have to cut expenditures to cover their dividends. At the same time, you’re seeing a gradual penetration of things like electric cars in cities.

Probably, we are looking at a longer-term period of oil well below $100, with periodic spikes to extremely high prices. You either see oil prices in the $50 to $60 range for many years, or you see oil being pushed out, and I’m not sure which it is.


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