Crude oil: It’s a turning point

Whilst volatility has fallen across all financial markets in recent years, the decline in oil has been especially steep. Implied volatility for front month Brent futures prices of less than 15% recently is only half of its 3-year average, a much bigger decline than the VIX, for example, which has fallen by only a quarter relative to its long-term average.

Oil market bears argue that this exceptional tranquility in oil markets reflects structural shifts in oil supply and demand that will persist and bring significantly lower price levels.

We disagree. True, global oil demand growth has deviated very little in recent years, slowing to a sedate 1-1.2m bpd as the expansion in Chinese energy demand has decelerated. Furthermore, the dramatic and largely unforeseen growth in US tight oil not only is reducing its own reliance on oil imports, but also means that the world is now able to meet oil demand growth without relying nearly as heavily on OPEC to fill the gaps as it used to.

False sense of security

However, whilst OPEC has not got the same leverage in oil markets it did when it was the only source of supply growth for most of the past decade, its role as a swing producer in smoothing out supply and demand fluctuations is still vital and due for another big test in Q3.

A combination of better global growth, a seasonal step-up in oil demand and a moderation in non-OPEC supply growth due to problems in mature non-OPEC basins (such as the North Sea) and missed targets at new operations (for example, in Kazakhstan) means that OPEC will need to supply roughly 1m bpd more oil in H2 14 than in H1.

That would be difficult under normal circumstances, especially at this time of year, when Saudi Arabia, the only holder of any significant spare capacity in OPEC, sees its own summer oil demand for cooling move up substantially. It will be very hard indeed if there is any significant disruption to Iraq’s production.

That is why in the short term we are warning of upside risks to our forecasts for Brent crude, which stand at an average of $111/barrel for Q3. A sizeable disruption to Iraqi output, perhaps resulting from the kind of pipeline sabotage that cut Iraq’s production by 700kb/d for a short period in 2011, would quickly push oil prices up another 10%, to the mid-$120s, in our view, before Strategic Petroleum Reserve releases and a probable increase in Saudi output cap the upside.

Higher for longer

However, the real significance of Iraq’s troubles is the way it is pushing expectations for longer-term oil prices higher. In contrast to other recent periods of supply concerns in oil, the back end of the price curve is moving up much faster than the front. Compared with when Libyan output fell in 2013, prices at the front end of the curve are $3/barrel lower, but five-year forward prices are higher by $10. We think that move up in far forward prices is justified and that there is further to go.

First, because the move partly reflects the fact that Iraq is the only OPEC country planning any significant new production over the next five years. Other major OPEC suppliers have slowed or cancelled their new projects. Some are concerned about the risk of oversupply as US oil production accelerates and consuming nations seek to curb their oil demand growth by encouraging energy efficiency and the use of alternatives. Others need the cash for social spending to try to prevent a repeat of the Arab Spring uprisings.

Second, and despite the aforementioned efficiency efforts, forecasts of global oil demand have continued to shift higher due to robust emerging market demand and a resurgence in US oil consumption. In the IEA’s recent Medium Term Outlook Report, its projection of global oil demand in 2015 is 1m b/d higher than it was just a year ago and more than 2m b/d above the 2010 forecast.

Third, the costs of meeting future oil demand have escalated rapidly, as producers have to operate in increasingly more difficult regions, exploit expensive new reserves and build new infrastructure to support their operations. In the past two years, the IEA’s estimate of the average yearly spend on new oil production to which the industry must commit to meet future oil demand has risen over 40%, to $621bn (in real 2012 USD).

In a recent piece on oil market volatility, we voiced doubts over whether the long period of oil market stability would come to an end unless there is “a sustained long-term threat to crude oil supply”. In our view, the developing situation in the Middle East and especially Iraq does now present such a threat.

Alongside steadily increasing demand, low levels of spare capacity and a dearth of non-OPEC supply growth outside of the US, we think that the recent period of stability in oil market fundamentals is coming to end and that this likely heralds a phase of higher and more volatile oil prices.

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