Liebreich: Predicting oil prices is difficult, particularly ones in the future

Michael Liebreich, Chairman of the Advisory Board

Bloomberg New Energy Finance

Twitter: @MLiebreich

The single question I have been asked more than any other over the past few months is what effect the recent collapse in oil prices will have on clean energy.

Bloomberg New Energy Finance remains of the view that the impact will be moderate. It will also vary widely by sector, as we explained in our December press release. Where renewables compete directly with oil, the impact could be severe, and it could cast a pall over the electric vehicle and biofuels sectors. Mainly, however, renewable energy competes in the electricity markets with natural gas, so it is collapsing gas prices, not oil prices, which would cause real pain. Here there has been a shift, but not as dramatic as that affecting oil.

To counterbalance the impact of low fossil fuel prices, there are also powerful second-order effects that play to clean energy’s advantage. Lower oil and gas prices are dramatically improving the balance of payments of importing countries and regions, in particular Europe, Turkey, South Korea, India and China. A strengthening world economy should allow countries more ambition in dealing with CO2 emissions, particularly in the run-up to the Paris COP21 meeting later this year. A period of low oil prices is the perfect opportunity to remove fossil fuel subsidies, and we have already seen progress on this in India and Indonesia. Even in exporting nations, fiscal pressure may force a re-evaluation of the wisdom of subsidised electricity and fuels.

All of this would have been a different story had it occurred as recently as three years ago, before the dramatic drop in clean energy costs. Last week in Abu Dhabi, the World Future Energy Summit was buzzing at the news of ACWA Power’s 200MW Dewa solar project. At unsubsidised costs of 5.84 US cents per kWh, it represents a new global benchmark for solar prices.

So far, so good. However, the longer-term impact of lower oil and gas prices clearly depends on where they head over the coming years. Was the recent oil price drop a “flash crash”, quickly driving US unconventional oil producers out of the market (whether by accident or design), only to soar above $100/barrel quickly thereafter? Or is $50 the “new normal”, as others have predicted?

Edgar Fielder, US economist, once said: “He who lives by the crystal ball soon learns to eat ground glass.” Nowhere should that be truer than in the oil market. Amazingly, however, it appears not to be the case, not because oil analysts’ predictions are particularly accurate, but because there appear to be no consequences for getting them wrong. Long-time analysts, whether they fall into the “flash crash” or the “new normal” camps, continue to receive reverential coverage in the media, with no one asking whether they were as prescient at the beginning of 2014 as they are claiming to be at the start of this year!

For what it is worth, my own model of oil prices goes like this: if the oil price is above around $90/barrel, you get demand reduction – through suppressed economic growth, more efficient engines, increased use of public transport and so on, as well as competition from alternative technologies, including biofuels and electric vehicles; conversely, if the price goes below around $60/barrel, you get a surge of demand from faster economic growth, bigger vehicles in the developed world and the emerging middle classes in the developing world. So over any decent period the oil price should average somewhere in the range of $60 to $90/barrel.

Of course this simple economic model ignores geopolitical shocks, potential cartel behaviour and the “animal spirits” of the market. The price can move out of the zone either dramatically (think $140 in 2008) or for an extended period (think $100-plus between 2010 and 2014). In addition, it is entirely possible that the market is so riven by speculation – and so badly advised by its analysts – that it flips periodically from being above, to being below, the economically sensible range, averaging the right number but never equalling it (I have never had much time for the concept of market equilibrium).

My simple model may be almost useless for traders, but for anyone making long-term asset investments or designing energy policy it is probably as good as it gets.

As for cartel behaviour, back in 2008, before the Arab Spring, Saudi Arabia had a target oil price of $75 per barrel, up from a range of $22 to $28 as recently as 2004. In 2010, Saudi Oil minister Ali al-Naimi announced a new view, that consumers could bear a price in the $70 to $90 range. It was only in 2012, faced with the soaring cost of social programmes required to keep order in the kingdom, that Saudi Arabia changed its goal to $100/barrel. That target held until 2014, when a combination of softening demand and US unconventional production rendered it untenable and led to its abandonment.

The death of King Abdullah and the accession of King Salman, coming hot on the heels of the collapse in oil prices, will no doubt lead to much speculation about a new target range. While such speculation will no doubt keep the same bunch of failed oil analysts on our television screens all year, I suspect it is largely a waste of everyone’s time.

It is clearly in Saudi Arabia’s interests for people to believe it has price-setting power (at the very least it resulted in a flock of heads of state paying respect at the funeral of King Abdullah), but my suspicion is that it has no such ability, at least over the short-to-medium term. When oil prices hit $140/barrel, tipping the world into recession and spurring the development of alternative technologies, Saudi Arabia could do nothing to increase production quickly. As so brilliantly predicted in 2005 by the late Matt Simmons in Twilight in the Desert, they could not just open the taps without damaging their fields’ long-term productivity.

As for pushing up oil prices from a low level, it remains to be seen whether Saudi Arabia still has the power. It depends on OPEC having the cohesion to act together, something that has rarely been demonstrated over any extended period. It would require countries in severe financial difficulty – Bahrain, Venezuela, Nigeria and Iran come to mind – to turn the taps down, risking reduced income just as their economies are imploding. Venezuela’s fiscal breakeven is $140, Bahrain’s and Iran’s are $137, Nigeria’s $128 and Russia’s $102. These are already countries on the brink, with limited foreign reserves, and it is hard to see the year ending well for them. While they have been quick to lobby Saudi Arabia to cut production, they have offered no cuts themselves.

For its part, Saudi Arabia, despite a fiscal break-even at $95/barrel, has sufficient foreign exchange reserves to survive $50 oil for well over five years. Although it could equally survive a sharp cut in output, it does not feel much urgency to do so, at least until it has seen evidence of significant capacity being squeezed out of the world’s oil supply.

We are starting to see some such evidence. US rig counts have begun a precipitous drop, Baker Hughes’ for instance falling from 1,930 in October to 1,633 now. In previous oil price crashes their number has plummeted by 40% in the year after the peak price so, as oil-man T Boone Pickens has pointed out, there is much further to go. We have also seen companies ditch their plans for exploration in high-cost locations. Statoil has abandoned plans to prospect off Greenland; Shell has put its Arctic exploration plans on ice (forgive the pun); the major oilfield service companies, Schlumberger, Halliburton and Baker Hughes have all announced thousands of job losses; while the international oil majors are cutting their 2015 exploration budgets by 12-13%, the Canadian Association of Petroleum Producers estimates its members will be cutting by 33%.

All this will arrest the growth of oil capacity, but it will take a few years for it to work its way through into lower non-OPEC output. Some of the abandoned plans would not have yielded oil for five, 10 or even 15 years. Much US shale oil may be unprofitable at current crude prices – Bloomberg New Energy Finance has identified 19 shale plays that lose money at $75 or below – that does not mean productive wells will be shut in: they will continue to produce declining amounts of oil for the next few years. And again, there are second-order effects: with the unconventional oil bubble well and truly burst, some of the extraordinary inflation in drilling costs will now unwind – no more South Dakota truck drivers earning $100,000 per year – so the breakeven for unconventional drilling will quickly drop, perhaps by as much as 20%, keeping more operations in business than one might expect.

In Davos, Claudio Descalzi, chief executive of Italy’s Eni, claimed that an extended period of low prices and reduced investment might in due course lead to $200 oil. But then, as the saying goes, he would say that, wouldn’t he?

For the truth is that the demand side too is providing downwards pressure on oil prices. China’s growth is now settling at around 7% per year, with the potential for further surprises to the downside. India might accelerate due to Prime Minister Narendra Modi’s reforms, but it is a much smaller economy than China’s, and not yet able to absorb much of the world’s oil production in the near term. Meanwhile demand in the developed world continues to decline. Almost every indicator of oil demand in the US peaked between 2004 and 2007: number of cars, miles driven, fuel inefficiency. Since 2007 the US economy has grown by 8.9%, while the demand for finished petroleum products has declined 10.5%. The picture is even starker in Europe, which remains mired near to recession, and Japan, which is still struggling to exit its 20-year stagnation.

All of this suggests an oil price towards to the bottom end of my $60-$90 range, not just in the short term but for a good few years. BP chief executive Bob Dudley has said that his company is assuming there may be low oil prices for as long as three years, and that certainly looks like a prudent assumption, and I would be surprised if oil finishes the year above $60.

And there you have it. Like most leading oil analysts, I have provided a cogent argument as to why prices are unlikely to move very far from where they are in the near term. However, before you hail me as a new oil price guru, let me just say I wish I had forecast $60 oil at the beginning of 2014, rather than the beginning of 2015!

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