Over the last 12 months, oil prices have been on a consistent downtrend. From a high of $115 / bbl, oil prices have fallen closer to the $45 / bbl mark. More importantly, it shows no signs of relenting. The sharp fall in oil prices has been blamed on a variety of factors. To begin with, the US shale production has been growing at a record pace over the last 4 years and the output continues to grow despite more wells idling. Secondly, the OPEC has decided to stop playing oil policeman and decided that it is not interested in regulating the price and supply of crude oil any longer. Thirdly, new supply push has come from Africa, Iraq as well as the likelihood of Iran being brought back into the global trade circuit.
While each of these factors is true, what is actually driving oil prices down today is the urge to stockpile oil. It is a fairly interesting phenomenon. Most countries maintain a strategic oil reserve to take care of their energy needs in difficult times. Countries like the US and China have been stockpiling oil to record levels. This creates an interesting situation. Because prices are low, most countries find a distinct price advantage in stockpiling oil. At the same time, huge stockpiles automatically depress prices creating a vicious cycle of stockpiling demand and low prices. The only way this cycle can be broken is if there is a surge in industrial demand from China, which looks unlikely with its GDP growth falling closer to 6%.
It is really a huge stockpile of oil…
According to the International Energy Agency (IEA), the total stockpile globally has increased to 3 billion barrels. The stockpile has increased by close to 20% in the last 5 quarters, sharply depressing oil prices. The key reason oil stockpiles are building up is that supply of crude oil continues to exceed demand for oil, month after month. That, by itself, is adding to the stockpiles of oil.
There could be only one immediate upper limit for stockpiling and that could be the limits on storage capacity. Already, storage capacity in the eastern hemisphere is nearing full capacity, but that is still some time away. In the coming year, the US and non-OPEC output is expected to fall bringing about a greater parity between demand and supply of crude oil. But it will be well beyond 2016 before the stock piles will stop putting a ceiling on oil prices. At least, till then oil prices will continue to be under pressure.
But it could be all about cheap money, honey…
At the end of the day, country level economics will dictate the future trend of oil. Let us take the case of the Middle East nations. The largest oil producer in the OPEC, Saudi Arabia, is already under tremendous budgetary strain. Their fiscal deficit is well above 20% and according to estimates, at this rate Saudi Arabia will run out of money in the next 4 years. Saudi and many smaller Arab nations now realise that strategy of drawing down on your currency reserves to meet the budget deficit is not exactly a sustainable scenario. This could impel the Middle East nations to adopt a more pragmatic approach to oil pricing in the coming year.
The real joker in the pack, however, could be funding costs. Aggressive shale production and rapid stockpiling of oil has been successful because of low funding costs. All that could rapidly change if the US starts raising rates in December this year. A higher cost of funding may actually make holding on to stock piles unviable just as it may make aggressive shale drilling also unprofitable. That could very rapidly change the dynamics of global prices.
The best case scenario, however, could be that oil prices will perhaps remain depressed below the $50 mark for the whole of 2016. The dual impact of a pick-up in Chinese demand and higher funding costs may actually see a reversal in oil prices as nations will find it increasingly difficult to sustain low oil prices. That may be the point when oil prices could bottom out and resume their trend upwards. But for now it looks like the era of cheap oil is here to stay!
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