Introduction

The fall in the price of oil has been a major talking point over the past eighteen months. With oil at the centre of global economy, a continued fall in the price of oil may have detrimental effects on oil producers, whilst the economies of heavy oil consumers may receive a much needed boost.

This article looks at the outlook for Brent crude in 2016, with particular focus to the fundamentals that are likely to drive the pricing of oil.

The Oil Price


In June 2014 the price peaked at 115.68, and has been plunging ever since. Fig 1 shows the price of crude oil, over the past five years.


Fig 1: Weekly chart of Brent crude

With nothing seeming to put an end to the decline in the oil prices, the beginning of 2016 posed new challenges to the price of oil which saw the price plunge to new lows in the 30s. The major question that most people are asking is how low can the price of oil go?


FUNDAMENTAL ANALYSIS


Cost of production

The starting point in the analysis is answering the question, “How much does it cost to produce a single barrel of oil?” Fig 2 below shows the median estimates for the all-in production cost (this includes the cost of discovery, extraction, transportation, overheads, etc.) for one barrel of oil across each of the major oil-producing countries.


Fig 2: Median Total Cost of Oil Production per Barrel

As is evident in Fig 1, the cheapest oil to produce comes from Kuwait, where the barrel cost is $8.50. Saudi Arabian crude costs $9.90 a barrel to produce and Iraqi crude costs $10.70 a barrel to get out of the ground but the median producer in a number of countries is already at a point where new exploration projects have become unprofitable. At this juncture it is important to note that the median total cost of production doesn't tell the whole story. There is a huge difference between the cost of exploring and producing brand new oil and simply extracting from the existing rigs. For example, Moody's estimates that it costs an average of USD13.68 in the USA to bring one barrel to the surface at an existing oil field. This means firms can continue to profitably produce from current reserves even if they stop exploration.

Global Supply


Since the 27 November 2014 OPEC meeting, the investors have been focusing on when production will throttle back due to the low oil prices. However as the battle for market share rages on it is highly unlikely that we will see the global supply levels being reduced.

In December 2015, OPEC elected to maintain current oil production levels despite apparent disagreement among members about the strategy. The biggest oil producers grouping established a record high production cap of 31.5 million barrels per day, which effectively endorsed current levels that were already in excess of the previous limit of 30 million barrels per day, after the nations had accelerated production in an effort to protect its market share from the North American operations. Global oil supply inched up 50 thousand barrels per day in November 2015 to 96.9 million barrels per day with total supplies now about 1.8 million barrels above November 2014 figures. Saudi Arabia, which is the biggest oil producer is on record saying it has no intention of cutting its supply to support oil prices, unless other producers such as Russia, Iran and Iraq agree to reduce their oil production.

Another factor going to increase the supply statistics in 2016 is the Iranian oil. After years of international sanctions, Iran has been cleared to export its oil and readies itself to regain the lost market share with a production target of more than 2 million barrels of oil per day.

Therefore going into 2016, the biggest driver for supply will be protection of market share rather than market price or the cost of production. Unless a decline is witnessed in the production figures of the Non-OPEC producers, then the global supply will most likely remain at the current levels.

Global Demand


The biggest question when addressing demand issues, is how much oil is being bought and consumed at the current prices?

There have been signs that the global oil demand growth has been responding favourably to the low price environment. However the growth has been slow and it is very difficult to ascertain how much of the growth has gone into stockpiling in places like China, India and the USA. The USA, has one of the largest storage facilities in the world, has continued to see its crude oil inventories escalate as shown in Fig 3.

Fig 3: US Weekly Crude Oil Inventories in the period 2013-2015

If the current demand is propelled by stockpiling, then there is a limit to which the countries can hold, therefore the demand for stockpiling will soon die down unless new storage space is created.

The IEA has forecast that global demand growth to slow to 1.2 million barrels a day in 2016 after surging to 1.8 million barrels in 2015 as highlighted in fig 4.

Fig 4: Annual Oil demand growth.

The economic slowdown in China and the downturn in most emerging economies is likely to put downward pressure on the demand levels.

Geopolitical tensions


Tensions and conflicts in oil producing nations have historically had a negative impact on supply, resulting in the price soaring. The Iran-Saudi Arabia tensions in early January 2016 is the latest edition in the chapter. The two biggest oil producers are embroiled in a fiery diplomatic stand-off which saw the price of crude oil jumped US $1.35 a barrel but dropped back down to $36.76 by the end of the day. Geopolitical jitters nudged oil prices after Turkey downed a Russian jet in November 2015 and the price of crude jumped more than 2%.

The current ratcheting up in tensions between Saudi Arabia and Iran only further confirms the school of thought that Saudi Arabia is unlikely to cut its output to help Iran regain market share. The geopolitical tensions are also unlikely to lead to price increases in 2016 as the brimming crude oil stocks offer an unprecedented buffer against geopolitical shocks or unexpected supply disruptions.

Price Outlook

Global oil markets will remain oversupplied in 2016 as demand growth slows. If supply continues to outstrip demand, then the only thing that is inevitable it a continued slide in the price.

The EIA forecasts oil prices averaging $40 per barrel in 2016, down 23% from 2015, and then rebounding to average $50 in 2017, which will still be lower than the 2015 average of $52.

In my opinion the EIA is being too optimistic in their projections. The main reason for this is than the EIA made base case assumptions of the following factors:
  • The decline in U.S. crude production.
  • The rise in Iran's production.
  • The rise in China's oil consumption.
However whilst Iran will come to the market with increased production, countries like Russia and Saudi Arabia which had eaten into their market share will be unwilling to surrender it on a silver plate. This may mean increased production from the other member. The impact of this all will be to cancel out the anticipated production cut from the US. The Chinese economic growth is also expected to slowdown in the coming 5 years with the IMF projecting growth rates of 6.3% in 2016, 6.0% in 2017 and 6.1% in 2018. With storage space likely to be limited in the come years, the consumption will most likely to similar to the current levels. It is against this background that project the oil price to average USD30-35 per barrel in 2016 with the possibility of seeing prices in the low 20s in the year and USD 40-45 in 2017.
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