I wanted to write this column last week but just got a little too involved with the three pieces that I ended up writing on Indian real estate.
As I write this column, the price of brent crude oil is around $48.8 per barrel. This price is expected to fall further over the next two months, for the simple reason that oil inventories all over the world have shot up dramatically.
In a research note titled How Low Will Oil Price Go and dated January 6, 2015, analysts at Bank of America-Merrill Lynch explain this phenomenon. The question is why do inventories build? “Inventories typically build because supply exceeds demand in any given market. But in some markets like oil or gas, storage capacity is a finite number and price declines can accelerate as inventories build.”
In another research note titled Oil price undershoot; Compelling value emerging and dated January 16, the Bank of America-Merrill Lynch analysts note that: “Inventories all over the world are building at a very fast rate. In fact, we have moved up our storage numbers and now expect OECD (Organisation for Economic Co-operation and Development) inventory levels to reach 2,830 million barrels in 2Q15, 180 million barrels above last year.”
Interestingly, oil inventory levels in the United States are at an 80 year high for this time of the ear. Numbers released by the Energy Information Administration(EIA) of the United States on January 16, 2015, shows that oil inventories in the country stood at 397.853 million barrels. Thus the oil inventories “are at the highest level for this time of the year in at least the last 80 years,” the EIA said in the release.
Typically in the past, as supply would increase the Organization of the Petroleum Exporting Countries (OPEC) would cut production and that would prevent a fall in oil price. Nevertheless that hasn’t happened this time around. In fact, Ali al-Naimi, the oil minister of Saudi Arabia, said in a December interview that: “It is not in the interest of Opec producers to cut their production, whatever the price is…Whether it goes down to $20, $40, $50, $60, it is irrelevant.”
The Saudi Arabia led OPEC has essentially been driving down the price of oil to make it unviable for US shale oil firms to keep producing oil. As Niels C. Jensen writes in The Absolute Return Letter for January 2015 titled Pie in the Sky: “In effect, OPEC is trying to destroy the economics of this industry, which admittedly requires quite high oil prices to remain profitable. Only 4% of total U.S. shale production breaks even at $80 or higher. A high percentage of the industry breaks even with an oil price in the $55-65 range.”
Due this OPEC oil production has not been cut and oil inventory levels world over have been shooting up. As land-based inventories start to fill up, the oil inventory will move to ships. “In fact, we see floating storage coming into play over the coming months with roughly 55 million barrels building on ships by the end of 2Q15, as land-based inventories across North America, Europe, and Asia fill up. But even floating storage is limited by its very nature. If crude vessels fill up, shipping rates will spike, and that is unlikely to help any oil producer in the world,” write the Bank of America-Merrill Lynch analysts.
Taking all these factors into account the Bank of America-Merrill Lynch analysts predict that by March 31, 2015, the price of brent crude is oil all set to fall to $31 per barrel. The question though is where will oil prices go from there. That is where things get rather interesting and as I have written in the past, it is very difficult to start predicting oil prices in the short term.
The answer to where oil prices are headed in the short=term probably lies in trying to understand how will oil supply shape up in the months to come. The non-OPEC oil suppliers need to cut oil supply by at least one million barrels per day to restore some sort of equilibrium in the oil market. But how good are the chances of something like that happening?
The Bank of America Merrill Lynch analysts point out that the cash cost of non OPEC producers comes at around $40 per barrel and given that oil prices need to stay below that for a while to get them to start cutting supply. “Many producers are well hedged, face very low cash costs, are partially protected by falling domestic currencies or tax breaks, or are notoriously slow to react,” write the analysts.
Oil companies in Brazil need $23 per barrel to cover their cash cost. Russian producers are well protected because of a huge fall in the value of the rouble against the dollar and have cash costs of around $9-15 per barrel. In case of the major oil companies ,the cash costs range anywhere between $20 to $42 per barrel. Only oil produced in the North Sea has an average cost of around $48 per barrel, which is around the current brent crude oil price.
Hence, non OPEC oil can still continue to produce oil for a while, leading to higher inventories. Given this, Saudi Arabia remains the joker in the pack and depending on which way it goes will decide the way oil prices head in the short term.
From the political posturing that Saudi Arabia has indulged in, it looks highly unlikely that OPEC will cut oil production any time soon, even though the country is losing a lot of revenue by keeping the market oversupplied.
As Brahim Razgallah of JP Morgan writes in a research report titled Saudi 2015 Budget: More than meets the eye and dated January 9, 2015: “All else equal, every $10 per barrel fall in the average oil price widens the fiscal deficit by 4.1%-pts of GDP.” Fiscal deficit is the difference between what a government earns and what it spends.
This deficit is likely to be financed through borrowing. The public debt of Saudi Arabia stands at a rather minuscule 1.9% and hence, it can easily borrow its way out of trouble. Over and above this, the country also has a huge amount of foreign exchange reserves amounting to $734 billion accumulated over the years by selling oil. This money can also be accessed.
Razgallah of JP Morgan believes that: “The 2015 budget deficit will mainly be financed by domestic resources, in our view, with public debt likely to reverse its downtrend from 1.9% of GDP in 2014. We believe the government is unlikely to draw on its external savings (97% of GDP) unless oil price weakness lasts a few years.”
Given this, the way Saudi Arabia behaves in the time to come will decide which way oil-prices head in the short term. And that remains difficult to predict.
(The article originally appeared on www.equitymaster.com as a part of The Daily Reckoning on Jan 27, 2015)