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Oil at USD 100/barrel – better for consumers, no worries for producers
Nordea Commodities Research:
Not surprisingly, oil prices continue to drop sharply today by 1.9%, but it is now trading just above USD 104/barrel. Increasing panic triggered a flight from risky assets such as oil and equities to the safe havens of gold, the CHF and the JPY after the credit rating agency Standard & Poor’s downgraded the US sovereign debt from AAA to AA+ with a negative outlook Friday. Yesterday’s oil price fall at -5.1% was unusually large by historical standards. Only around 15% of the daily oil price changes (or around 400 trading days for the last 10 years) in absolute terms since January 2001 have exceeded 3.2% (absolute terms) or one standard deviation.
We do not expect the S&P downgrade of US debt to have a long-lasting impact on the financial market or the economy and thereby the global oil demand outlook, but it clearly adds to the market uncertainty at a time when advanced economies are very fragile. Increasing market uncertainty is expected to weigh on oil prices in the short term.
In the longer term, macroeconomic fundamentals will take over as the key driver of oil demand. Whether the US economy is able to move out of its current soft patch or not will be important for the medium-term oil demand regardless of the recent downgrade. Although the emerging economies are expected to be the main driver of future oil demand growth, the US is still the largest oil consumer in the world at 20% of global oil consumption. Thus, a sharp slowdown or a recession in the US economy may cause a massive sell-off in oil and trigger a sharp fall in oil prices from the current level. The US economic gloom has clearly started to affect oil demand. The underlying trend (measured by the 4-week moving average) in US total oil product demand has been weak and at the low end of the 5Y range. Especially the underlying trend in petrol demand has been pointing downwards and is now below the 5Y range, indicating a weaker trend for US consumers. By contrast, the trend in distillate demand is still at a decent level, suggesting that industrial activity has still not been hit by the market uncertainty and higher prices to the same extent as US consumers. Unfortunately for the growth outlook, consumer spending accounts for 70% of US economic growth.
Although oil prices in a worst-case scenario may fall markedly from today’s level as a result of increasing market uncertainty that may trigger another financial crisis and a new recession, we do not expect to see oil prices fall to the lows in December 2008 when Brent crude traded at USD 36.61/barrel. One reason why prices should not slump as far as during the financial crisis in 2008/09 is that we expect OPEC to start cutting oil production earlier in the cycle than it did during the financial crisis as huge spending packages to try to prevent further uprising in the MENA region have in our opinion pushed up OPEC’s breakeven price of oil – the price at which its budget is balanced while accommodating greater public spending. We expect the preferred unofficial price range to have moved to around USD 85-105/barrel from USD 70-90/barrel in 2008/09.
Another reason is the rebalancing process of the IEA emergency stocks. The refilling process in the IEA member countries should counterbalance the more bearish oil demand outlook for the advanced economies and contribute to tightening the market. China has also indicated that the country will continue to fill its strategic oil inventories. We would not be surprised to see increased buying from the Asian growth engine if oil prices fall markedly. China clearly used the opportunity to fill up its commodity inventories when commodities prices dived during the 2008/09 financial crisis and global recession.
How far can oil prices fall before we see lower oil prices starting to influence oil investments and put new oil production projects at risk? The global marginal cost of a new project is on average around USD 85/barrel. New high-cost conventional projects, oil sand projects, gas-to-liquid, coal-to-liquid and oil shale production, require oil prices in the area of USD 60-100/barrel. New medium-cost conventional oil projects, for example in the North Sea, the US Gulf of Mexico, the Caspian Sea, most Latin American projects, in Africa and the Far East, require oil prices in the range of USD 40-60/barrel. And new low-cost Middle East production needs prices in the range around USD 15-40/barrel. Despite a somewhat weaker oil demand outlook especially from the US, we do not see oil investment in the North Sea at risk and thereby the activity level of the oil industry (both upstream and downstream) in Norway, Denmark or the UK being affected if oil prices continue to trade at the current level around USD 106/barrel or even markedly lower in the range down to USD 60/barrel.
In NOK terms the Brent oil price has fallen by around 4% to around NOK 569/barrel (closing price Monday) since the announcement of the S&P downgrade Friday. The oil price is still well above the oil price expected by the Norwegian Ministry of Finance in the Revised National Budget at NOK 575/barrel for 2011. The average Brent oil price year to date is NOK 625/barrel or NOK 50/barrel on average above the budgeted oil price for 2011. This should increase the state’s net cash flow by around NOK 24.5bn for 2011 if the oil price stays at NOK 625/barrel for the rest of the year.
In the short term, waves of risk aversion may trigger temporary sell-offs of oil and dips in oil prices and we leave our average Q3 oil price forecast unchanged at USD 110/barrel. In Q4 we still expect the oil supply/demand balance to tighten, but at a somewhat slower pace on the more gloomy US economic growth prospects. Continuous supply outages in Libya and a fading effect of the IEA emergency stock release should counterbalance a more bearish outlook for US oil demand growth. The OPEC spare capacity buffer will still be under pressure for a while as the fighting in Libya continues. In total, 1.25m b/d of Libyan oil exports have been cut off and we do not see any restoration in sight. Disruption risk remains high also in other MENA countries with increasing domestic instability such as Syria and Yemen.
The recent increase in uncertainty and weaker economic performance in the US and the Euro area may reduce some of the upward pressure on oil prices in Q4 and increase the downside risk to our Q4 USD 118/barrel oil price forecast.
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