Is there a new paradigm for oil pricing?

The New York Times published an article on 22nd April, headed ‘New Balance of Power’, claiming that ‘the United States’ is overtaking the Organization of the Petroleum Exporting Countries (OPEC) as the ‘vital global swing producer that determines prices’.

It went on to say US is ‘creating a new paradigm in which global oil prices are likely to settle into a long-term equilibrium of $70 - $80, driven by supply and demand dynamics rather than by ‘overt manipulation’ by OPEC’. In the English-speaking world at least, where the US dominates both commentary and sentiment, this viewpoint is beginning to look like received wisdom.

Also in April, US Energy Secretary Ernest Moniz, said “We anticipate becoming big players, and I think we’ll have a big impact”. “We’re going to influence the whole LNG market”. According to the Daily Telegraph (26 April) the US is “poised to flood world markets with once-unthinkable quantities of liquefied natural gas as soon as this year, profoundly changing the geo-politics of global energy and posing a major threat to Russian gas dominance in Europe”. Clearly, OPEC lacks a monopoly on market manipulation.

Russia, Saudi Arabia and the USA are much the largest oil producers. All three have potential to be a ‘swing producer’, show active interest in geopolitics, and willingness to use hydrocarbon production in pursuit of their geopolitical strategy.

So is there going to be a new paradigm for oil pricing, and a new swing producer? We think so, up to a point. The United States is the world’s leading exporter of refined products; it consumes most of its own production of crude but new policy looks likely to change this. Of the big producers, Saudi Arabia can increase or decrease its production most easily, cheaply and quickly. Their average cost of production per barrel is the lowest of the three, and they have the largest proven reserves; we believe they will remain the most important swing producer.

Oil prices will continue to be extremely difficult to predict. Every few years, a geopolitical shift causes a big price movement, but such shifts are unpredictable even for catastrophe modellers. Apart from this, little happens apart from short-term small oscillations, as at present. Much commentary appears, rapidly-deployed hindsight masquerading as foresight, explaining every movement as everyone hopes to move the market. Unfortunately, rationales for movement in the opposite direction are always just as convincing.

These short-term oscillations (and the proffered explanations) matter little. In recent weeks a ‘lightening of the mood’ once the US holiday and golf season starts, has been much anticipated. This ‘could lead to an increase of $5 per barrel’. There is some substance in this; Americans drive more in summer so refineries adjust demand accordingly, but we expect little impact on prices as stored inventories anticipate this well-known effect. Over the last 30 years, we see no significant seasonal effect in WTI or Brent prices except that price rises happen more often than expected on Thursdays and Fridays; falls are more common on Mondays and Tuesdays as hedged positions covering the weekend are unwound. Maybe.

For the next few years, geopolitics will dominate supply and demand in determining prices. In the long-run, fossil fuels are finite resources, reserve replacement ratios are tending downwards, exploration costs are rising and demand increases with economic growth, about 3% a year; all factors which move prices upward. In the short-run, the market is oversupplied, but the speculative futures market, which may bear little relation to physical demand, has pushed prices upward.

We see $75 as the magic number which will give green light to many projects now on hold, if sustained, and as likely as not $80 per barrel for Brent some point before the year end, but this may not last.