Alphabet soup
Forecasting oil price recovery
When it comes to where the price of oil is going,
there are a lot of questions (and potential answers)
to consider.
Will it bounce back quickly – or sometime in the
distant future? How high will it go? What will happen
to LNG prices? Will they bounce back? And what
factors weigh most heavily on determining the shape
of any price recovery?
The heady days of US$110 oil certainly look to be many
years out, with the oil futures forward curve pointing to
a gently rise in prices for many months, and not back to
US$90 (as in September 2014) until 2018. Oil traders are
therefore betting that demand (from Europe, the US and
Asia), and supply (OPEC cutbacks, cancelled Canadian oil
sands expansions, US shale shut-ins), will only gradually
balance, leading to at best a prolonged, incomplete and
gradual recovery.
But are they right? There are a few other factors to
consider when it comes to potential to influence a
sudden, sharp and accelerated upward price shift:
• An OPEC change of heart – could OPEC change
its policy towards natural market balancing at its
upcoming June 2015 meeting?
• A Russian play for growth – Russia’s economy is
highly dependent on a high oil price, it’s government
is particularly skilled in the fine art of using oil and
gas for political means, and it’s unpredictable
• A policy shift in Beijing and/or Washington –
watch the likes of China’s air quality this winter,
the Keystone XL decision, the pace of approvals
for more US oil exports, and the upcoming US
election to detect potential shifts in climate agenda
as an oil price influencer
• A natural disaster – tsunamis, earthquakes and
hurricanes can drive price shifts (although hoping
for one is clearly not good strategy)
• Demand resurgence – cheap oil stimulates
greater consumption which will lift the price
• Supply failure – finding fresh supplies to replace
what’s been produced is no easy task anymore.
Supply will eventually fall short against a relatively
inelastic short term demand.
For now, the pressures exerting downward force
on prices show no signs of letting up. Technology
advancement is increasing the energy efficiency of
consuming devices, and making every drop of fossil
fuel stretch further (although history teaches us that
we rarely bank these savings). Research into fracking
and drilling technologies, well monitoring and
reservoir simulation will continue to help expand
shale basins, and battery technology improvements,
solar efficiency gains, and improved wind turbines
will lead to increased substitutes for fossil fuels.
During the GFC, economists came up with clever
ways to describe how a recovery might unfold,
including the LUV model (and hence the alphabet
soup reference). I’ve applied the same model to oil
prices, but think we also need a fourth curve –
what I call a reverse J (or the fishhook).
The V
In this scenario, oil prices rise quickly back to where
they were (favoured by OPEC and other producers
that are oil export revenue reliant). The forward price
curve suggests a V shape, albeit an oddly shaped one –
its right arm rising at a very shallow rate, pointing
to future prices below the peak.
The U
Oil prices settle in on some floor (optimistically in the
US$45-US$50 range), bumping along for a period
before rising quickly back to US$110. However US
shale producers continue to show short term
production growth, and traders are hoarding millions
of barrels for eventual release. To get a spike in prices,
we’d need to see a serious drop in production, the
elimination of stored inventory, a big spike in demand,
or some combination of all three (and none of which
are plainly visible at the moment).
The L
There is a real risk of this scenario – where prices
fall to a new level and never return. Carbon policies
in the US and China, research on the need to strand
fossil fuels, the rise of renewables, improvements in
battery technology to store power and eliminate fossil
fuel from transportation, the substitution of gas for
coal, all suggest that fossil fuel is becoming the stone
of the stone age. If these substitutes pick up pace and
market share to displace fossil fuels permanently, then
L is our future.
The reverse J (the fish hook)
Prices eventually rise but not to pre-fall levels. Cutbacks
in producer capital spending, project cancellations, and
workforce reductions plant the seeds for an eventual
reduction in supply that balances with demand. Ideally
OPEC picks up any spare share made available
by shale’s retreat.
To make the strategy work, OPEC countries need to be
ready to ramp up production once demand overshoots
supply. The worry is that in a low oil market, even they
lack capital to expand their production, a problem since
shale is going to be cheaper in the future as costs come
out, and because it can come to market via lots of small
wells, rather than the megaprojects typical of OPEC.
This suggests the price will settle at the marginal cost
of future shale production – between US$50 and
US$70/bbl.
This article originally appeared in Oil and
Gas Australia.
Contact
Geoffrey Cann
Partner, Consulting
+61 7 3308 7125
[email protected]
This publication contains general information only, and none of Deloitte Touche Tohmatsu Limited, its member firms, or their related
entities (collectively the ‘Deloitte Network’) is, by means of this publication, rendering professional advice or services.
Before making any decision or taking any action that may affect your finances or your business, you should consult a qualified
professional adviser. No entity in the Deloitte Network shall be responsible for any loss whatsoever sustained by any person who relies
on this publication.
About Deloitte
Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its network
of member firms, each of which is a legally separate and independent entity. Please see www.deloitte.com/au/about for a detailed
description of the legal structure of Deloitte Touche Tohmatsu Limited and its member firms.
Deloitte provides audit, tax, consulting, and financial advisory services to public and private clients spanning multiple industries. With
a globally connected network of member firms in more than 150 countries, Deloitte brings world-class capabilities and high-quality
service to clients, delivering the insights they need to address their most complex business challenges. Deloitte has in the region of
200,000 professionals, all committed to becoming the standard of excellence.
About Deloitte Australia
In Australia, the member firm is the Australian partnership of Deloitte Touche Tohmatsu. As one of Australia’s leading professional
services firms, Deloitte Touche Tohmatsu and its affiliates provide audit, tax, consulting, and financial advisory services through
approximately 6,000 people across the country. Focused on the creation of value and growth, and known as an employer of choice
for innovative human resources programs, we are dedicated to helping our clients and our people excel. For more information,
please visit Deloitte’s web site at www.deloitte.com.au.
Liability limited by a scheme approved under Professional Standards Legislation.
Member of Deloitte Touche Tohmatsu Limited
© 2015 Deloitte Touche Tohmatsu.
MCBD_HYD_05/15_051126