The Oil View: Fasten Your Seatbelts

Oil Price Volatility May Become Commonplace

Already, another day has dawned bringing more volatility in oil prices. WTI is trading at about $55.25 following an early low of $53.60; and Brent, which had traded as low as $58.55 this morning, is trading at $59.50. What do the experts think?

Late yesterday, CIBC World Markets’ Macro Strategy Research team sent out its research report entitled “The Oil View: Fasten Your Seatbelts” concerning the current oil price environment. CIBC’s Head of Commodities Strategy Katherine Spector summarized the findings in a note to clients. The summary is below:

• What a difference six months makes. Despite the ‘sky is falling’ turn in market sentiment since last month’s OPEC meeting, we are still medium- to long-term constructive on global crude prices. In light of recent events, it does look as though we are in for at least a six month bear market though, and are adjusting our forecast to reflect that.

• It wouldn’t have been too difficult for OPEC, or even Saudi alone, to clean up the current market overhang had they wanted to. By our count, if OPEC production remains unchanged from current levels (specifically, from estimated November production levels, which are already some 400-500 kbd below October levels thanks to lower production in Libya, Qatar and the Neutral Zone), there will be an average oversupply of about 1.3 mbd in the first half of next year, but that overhang disappears in the second half of next year.

• Is a 1.3 mbd supply overhang in 1H’15 a lot? If that oversupply doesn’t go away and shows up in commercial inventories, then yes, it’s a lot and it’s bearish. But it’s not a lot in the context of production cuts — either voluntary or involuntary. It wouldn’t have been a big cut for OPEC to make had they agreed to it, and — in the absence of an agreement — it’s the kind of cut that could turn up pretty plausibly in the list of unplanned global supply outages. That’s why we caution that — although this overhang is indeed bearish if it sticks around — it could also evaporate quickly.

• Let’s say producers get lucky, and there is no uptick in unplanned supply outages in the near-term. The earliest we would expect to see price-induced changes in either supply or demand is after six months of low prices. In the meanwhile, we will get some data points. In a sense, this is a grand experiment: oil prices have averaged more than $50/bbl for nearly a decade, and the five year trailing average price topped $100/bbl this year. That is unprecedented, and realistically we don’t really know how that sustained period of historically high oil prices has changed the price elasticity of either oil supply or demand.

• It is fair to assume that, all else equal, in a low price and therefore low investment environment tight oil production growth should slow more quickly than conventional. But that doesn’t mean that it will slow overnight. There is a tremendous amount of disagreement among very informed people about how low for how long prices need to be to slow US production growth, let alone reverse it. It is also difficult to draw a straight line between cuts in capital expenditures and reduced production growth.

• What we can say with some certainty is that if non-US, conventional non-OPEC oil supply didn’t grow at $100/bbl oil prices, it certainly won’t grow at lower prices either. Ironically, it is very possible that US producers won’t be the first to reflect the effects of low oil prices. As usual, acute unplanned outages in OPEC are hard to call, but we continue to see more downside than upside to production in the usual hotspots and this informs our constructive price bias.

• While market focus has been mainly on the impact that lower prices will have on supply growth, there is some uncertainty on the demand side as well. All else equal, lower prices should boost demand. But again, one thing we will learn during this bear market is whether several years of very high oil prices have structurally changed demand elasticity to price.

• We believe that the lower prices go now, the higher they will rebound later. The most bearish longer-term scenario is one where prices stick around the $80/bbl range for a protracted period of time. That’s not low enough for US producers (not to mention their lenders) to panic entirely, but low enough for them to work hard at optimizing operations, lowering costs, and maybe even knocking out some of the weaker members of the herd through consolidation. On the demand side, crude in the $80 range is probably not low enough to reverse efficiency or climate policies in consuming, but is low enough to encourage emerging market governments to eliminate oil price subsidies. That middle of the road scenario should be OPEC’s worst nightmare.

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