Analysis - Economic Trends

Three Indicators

Forecast for a gradual recovery in oil prices

Thursday، March 10، 2016
Three Indicators

On February 16, 2016, the Kingdom of Saudi Arabia, the Russian Federation, Qatar, and the Republic of Venezuela agreed, in a closed ministerial meeting held in Doha, on plans to freeze oil production at January 2016 levels, provided that other producers comply with the same arrangement. Holding this meeting came as a preferable, long-awaited-for, step to coordinate oil production among major exporting countries with the aim of limiting surplus market inflow. However, the impact of this declaration was relatively limited. Yet, there are many indicators which forecast a possible increase in oil prices in the coming period.

Limited effects of oil production freeze

Markets expected an agreement between Saudi Arabia, Russia, Qatar and Venezuela to cut – and not freeze – oil production. Accordingly, the impact of the last agreement is limited due to several factors, the most important of which are as follows.

1. Both Saudi Arabia and Russia – the two main actors behind the oil production freeze - together produce oil equal to maximum capacity or what are considered as ceilings on the volume of production. For Saudi Arabia, production capacity is estimated at approx. 12–12.5 million barrels per day (B/D). The Wall Street Journal reported that in January 2016 Saudi Arabia produced approximately 10.1 million B/D and that the state’s oil production is almost equal to its production ceiling according to the OPEC quota system.

According to World Economic Forum figures, Russia’s oil production in January 2016 was recorded at approximately 10.9 million B/D; signifying production at full capacity, signifying unprecedented production levels since the USSR era. Thus, it is hard to imagine that a freeze of oil production will lead to a tangible effect on oil prices in the short term.

2. The freezing of oil production in the above mentioned states is tied to other major oil producing countries adopting similar measures. Following the Doha ministerial meeting, the Qatari Minister of Energy and Industry stated that “the four countries, with the aim of stabilizing oil markets, agreed on freezing production at January 2016 levels, provided that other main producers follow by example”. This condition is hard to be attained, and two major producers – Iraq and Iran – do not want to abide by it. Both are largely increasing their production to make up for the shortages they suffered from due to either internal reasons, as is the case with Iraq, or international sanctions, as is the case with Iran.

It is worth noting that the Republic of Iraq announced that production levels reached record levels in January 2016, estimated at 4.775 million B/D, before falling back in February, due to technical reasons. Since December 2015, Iran’s oil exports increased by 200,000 B/D, according to a survey conducted by Reuters, and 500,000 B/D according to Iranian officials.                                                                                            

3. Saudi Arabia has drawn its future oil policy without decreasing its production. In an interview with Agence France-Presse, the Saudi Foreign Minister, Adel El-Jubeir, has asserted  two days after the Doha meeting that KSA is not willing to reduce its production, yet “if other producers limit production, this may affect the market.” This clear Saudi trend highlights the difficulty of future negotiations on production cuts by major producers within a comprehensive framework, where different parties share the required reduction.

In this regard, the Saudi position is fair and consistent with sound economic fundamentals. Many non-OPEC producers have previously rejected to cooperate with Saudi Arabia in order to regulate production to maintain high oil price levels. Moreover, very clear pressures were applied, specifically, in Saudi Arabia to reduce production to adjust the market.

However, market rules defy such logic that perceives a country with the least production costs should reduce its production to maintain high prices while allowing producers with high production costs to expand their production. Accordingly, whilst taking into account non-economic differences between the two major producers into consideration, Saudi persistence in maintaining its market share is expected to nurture global oil supply repletion, at least in the short term.

Surge in future oil prices

In light of the limited impact of Doha Meeting results on global oil markets, a question can be raised. Will this lead to continuous oil price reduction in the short and medium terms? The likely answer is no. Oil prices are expected to increase in the future; however, reaching prior mid-2014 levels of +100 USD per barrel is unlikely. Hence, a gradual increase in oil prices is expected due to several important factors as follows.

1. New oil production (shale oil in the US and oil sands in Canada) will not be able to compete on the long-term under current oil price levels. Although the US shale oil production is said to “persevere” decreasing prices, as it is characterized by flexibility, adaptability, and cost effectiveness along with technical development, reality proves otherwise. Shale oil production contributed to the increase in US oil production by 1 million B/D for each of the last three years prior to the decline in prices. However, this production was achieved by companies relying on loans which entail sustaining high oil levels of production. Because fixed overheads for the drilling of shale oil wells represent a higher cost element compared to operational costs, decreasing prices prove that carrying on with production is more feasible than production suspension. This underlies the previous remark on shale oil production “perseverance”.

It should be noted, however, that shale oil production decreases significantly when compared to traditional oil production, whereby well production is estimated to decrease by 60–70% during the first year of production. After two to three years, the shale oil well requires costly treatment to increase production. Thus, the production lifetime is limited, and the financial burdens on producers are high, due to the liabilities of loans utilized to finance production.

After a year and ten months of decreasing oil prices, it is not a surprise that after the “perseverance” of the US shale oil the number of drilling rigs has decreased significantly in February. There are currently 400 rigs, marking a 68% decrease compared to October 2014, the lowest level reached in the past seven years. Similarly, sand oil production in Canada has declined significantly during the recent period due to rising production costs, especially transportation in the winter, where the means of special heating methods to maintain viscosity, to enable refiners to use it.

2. Despite Saudi Arabia’s firm stance towards reducing oil production, there is a larger opportunity for more multi-lateral negotiations between major oil exporters to coordinate production sizes. Undoubtedly, the quartet ministerial meeting held in Doha last month could be followed by unannounced negotiations to coordinate oil production, leading to a fair coordination agreement. These meetings could start by the end of March, according to media releases.

3. The global economy will recover from the slackening economic conditions following the 2008 Global Financial Crisis which shadowed oil demand development. After nearly eight years since the crisis some indicators, especially in the US, show increasing potentials to overcome the slackening phase, which can contribute to a moderate increase in oil prices.

Finally, the last two years have been remarkable for energy actors in general. Whereas the change in supply and demand factors in the oil market is developing, there are other factors which influence energy markets in general and oil markets specifically. Technical development in some fields (such as electric cars) and increasing the efficiency and reducing the costs of producing fossil fuel alternative

Keywords: Saudi ArabiaoilRussiaQatarVenezuelaOil Production

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