1. NS4960 Spring Term 2016 Causes the 2014-15 Oil Price Decline
IMF, Seven Questions About the Recent Oil Price Slump, December 22, 2014

2. Introduction Main Points:
Oil prices fell sharply in the second half of 2015
Ended four year period of stability around $105 per barrel
Decline is much larger than that of other commodities
Oil prices are expected to remain low in 2015 and rise only marginally in 2016
Sources and implications of the sharp decline in oil prices have lead to intensive debate
Questions
How does the recent decline in oil prices compare with previous episodes?
What are the causes of the sharp drop?
World Bank, Global Economic Prospects, January 2015, Chapter 4

3. Oil Price Patterns I
Oil Prices

4. Oil Price Patterns II Comparison with Previous Episodes
Between five other episodes of oil price declines of 30% or more in a six month period occurred
These coincides with major changes in the global economy and oil markets:
An increase in the supply of oil and change in OPEC policy ( )
U.S. recessions and 2001
The Asian crisis , and
The global financial crisis (

5. Oil Price Patterns III

6. Oil Price Patterns IV
Many parallels between the recent episode and the collapse in oil prices in
After the sharp increase in oil prices in the 1970s, technological developments made it possible to
Reduce the intensity of oil consumption and
Extract oil from various offshore fields including the North Sea and Alaska
After Saudi Arabia changed policy in December 1985 to increase its market share
Price of oil declined by 61 percent between January-July 1986
Following this episode low oil prices prevailed for more than 15 years.

7. Oil Price Patterns V
In other commodity markets, episodes of large price declines:
Have mostly been observed in agriculture, typically associated with specific weather conditions
After reaching deep lows during the global financial crisis most commodes peaked in the first quarter of 2011
Since then prices of metals and agricultural raw materials have declined steadily as a result of weak global demand and abundant supplies
In contrast oil prices fluctuated within a narrow band around $105/barrel until June 2014
Softness in the global economy was offset by concerns about geopolitical risks, supply disruptions and production controls exercised by OPEC

8. Oil Price Patterns VI Apparent that stability until recently
Reflected in part willingness of Saudi Arabia and
Other low cost producers to withhold output in support of OPEC price objectives
Steep decline in second half of 2014 intensified after change in policy at the OPEC meeting in late November
By end of 2014 cumulative fall in oil prices from the 2011 peak was much larger than non-oil commodity prices
Currently, the oil markets have gone into are in contango – all spot markets are cheaper than forward contracts
When spot prices produce the same profits as purchasing and storage for future sales, markets have stabilized – may be nearing that point soon.

9. Oil Price Patterns VII
Commodity Price Indices

10. Oil Price Patterns VIII
Contango and backwardation in oil futures markets

11. Oil Price Patterns IX
WTI Futures Curves, 2014

12. Causes of the Oil Price Drop I
Causes of the sharp drop
For any commodity, underlying demand and supply conditions for oil determine the long run trend in prices
Short term movements in market sentiment and expectations (in some cases driven by geopolitical developments and OPEC decisions exert influence too)
Prices may drop rapidly to surprises in the news even before actual changes occur
In 2014 relevant events included
Geopolitical conflicts in some oil producing regions
OPEC announcements and
The appreciation of the U.S. dollar
Long term developments in supply and demand have also played important roles in driving the recent decline in oil prices

13. Causes of the Oil Price Drop II
Trends in supply and demand
Recent developments in global oil markets have occurred against a long term trend of greater than anticipated supply and less than anticipated demand
Since 2011 US shale oil production has persistently surprised on the upside by some 0.9 million barrels per day – about 1% of global supply in 2014
Expectations of global demand have been revised downwards on several occasions during the period as economic growth disappointed.
Global growth in 2015 is expected to remain much weaker than it was during the period when oil prices rose substantially
The oil-intensity of global GDP has almost halved since the 1970s -- result of increasing efficiency and declining oil intensity of energy consumption

14. Causes of the Oil Price Drop III
IEA Forecast of World Oil Demand

15. Causes of the Oil Price Drop IV
Change in OPEC Objectives
Saudi Arabia has traditionally acted as the cartel’s swing producer
Using its spare capacity to either increase or reduce OPEC’s oil supply and stabilize price within a desired band
Changed dramatically in November 2014 after OPEC failed to agree on production cuts
The OPEC decision to maintain production level of 30mb/d signaled a significant change in cartel’s policy objectives
From targeting an oil price band to maintaining market share
No doubt changed position reflects concern over increased competition from shale

16. Causes of the Oil Price Drop V
Receding geopolitical concerns about supply disruptions
In second half of 2014 became apparent that supply disruptions from conflict in Middle East
Had lessened
Or did not materialize as expected
In Libya despite internal conflict production recovered by 0.5 million barrels a day (about 0.5% of global production) in the third quarter of 2014
In Iraq, as advance of ISIS stalled, became apparent that oil output could be maintained.
In addition the sanctions and counter sanctions imposed after June 2015 as a result of the conflict in Ukraine have had little effect on oil and natural gas markets thus far

17. Causes of the Oil Price Drop VI
U.S. dollar appreciation
In the second half of 2014 the U.S dollar appreciated by 10% against major currencies in trade-weighted terms
A U.S. dollar appreciation tends to have negative impact on the price of oil
demand can decline in countries that experience an erosion in the purchasing power of their currencies
Empirical estimates very greatly
The high estimates suggest a 10 percent appreciation is associated with a decline of about 10 percent in the oil price
Low estimates suggest a 3% or less

18. Causes of the Oil Price Drop VII
Speculation
Beyond traditional demand and supply factors some have suggested “financialization” of oil and other commodities as a factor leading to the price decline
Leads to greater likelihood of speculation in commodity markets
Little hard evidence that this is the case in the recent price drop
Latest IEA report indicates that oil inventories reached their highest level in two years
Suggests expectations were of a price increase not decrease

19. Short-Term Drivers of Oil Price Decline I

20. Short-Term Drivers of Oil Price Decline II

21. Short Term Drivers of Oil Price Decline III

22. Long Term Drivers of Oil Price Decline I

23. Long Term Drivers of Oil Price Decline II

24. Future Supply Conditions I
2. How persistent is the supply shift likely to be?
Depends on two factors
First is whether OPEC and in particular Saudi Arabia will be willing to cut production in the future
This depends in part on the motives behind the change in its strategy and the relative importance of geopolitical and economic factors in that decision.
One hypothesis is that Saudi Arabia has found it too costly in the face of steady increases in non-OPEC supply to be the swing producer and maintain a high price
If so and unless the pain of lower revenues leads other OPEC producers and Russia to agree to share cuts in the future – strategy unlikely to change

25. Future Supply Conditions II
Another hypothesis is that it may be an attempt by OPEC to reduce profits, investment, and eventually supply by non-OPEC suppliers – some of whom face much higher costs of extraction than the main OPEC producers
The Second Factor is how investment and in turn oil production will respond to low oil prices.
There is some evidence that capital expenditure in oil production has started to fall
One estimate is that overall capital expenditure of major oil companies is 7 percent lower for the third quarter of 2014 compared to 2013
Available projections indicate that capital expenditures will fall markedly throughout 2017

26. Future Supply Conditions III

27. Future Supply Conditions IV
For unconventional oil such as shale (which now accounts for 4 million out of a world supply of 93 million barrels a day), the break even prices – the price at which it becomes worthwhile to extract in the U.S. are typically below $60 per barrel
At prices around $55 per barrel, projections suggest that the level of oil production could decline but only moderately by about less than 4 percent in 2015
Rates of return will be significantly lower
However, some highly leveraged firms that did not hedge against lower prices and are already under financial stress and have been cutting their capital expenditure and laying off significantly

28. Future Supply Conditions V

29. 2. Supply Conditions VI Break-Even Prices for U.S. Shale basins
Lower Oil Prices Are Putting the Freeze on Fracking Projects Around the World Business Insider December 8, 2014

30. Future Supply Conditions VII
Other things being equal the dynamic effects on supply should lead to a decrease in supply relative to the initial shift and thus to a partial recovery of prices
This is what is suggested by futures markets which now show an expected recovery of prices to $73 a barrel by 2019
The uncertainty associated with these forecasts comes not only from supply, but also demand factors
On the supply side:
Possible changes in OPEC’s strategy and
Geopolitical tensions in Libya, Iraq, Ukraine and Russia should not be underestimated

31. 2. Supply Conditions VIII
On the demand side
Uncertainty about global economic activity and thus the derived demand for oil remains high
Shown by the size of the implied distribution of futures prices (based on options prices)
The 68% confidence band for the price in 2019 ranges from $48 to $85, the 95% band from $38 to $115% -- very large band by historical standards

32. IMF Forecasts January 2015
WTI Crude Forecasts

33. Update I

34. Update II

35. Update III

36. Update IV