How long will crude prices stay low?

Crude has fallen by over 60 per cent since last June. I don’t recall any analyst predicting such price capitulation. It was a rare and difficult event to foresee and could be categorized as what mathematician Nasim Nischolas Taleb calls a ‘black swan event.’

With crude prices trading at eight year lows, one of the most crowded trades still remains a sell on rallies in oil. Every market participant is talking about the new normal in energy prices, the shale revolution, end of the commodity super-cycle and the beginning of the end for OPEC member nations and their pricing power.

This column is of the view that one of the biggest macro risks of 2015 is a V-shaped recovery in oil prices. This scenario is not as farfetched as many currently believe it to be. The drop in energy prices has been more a function of supply side factors than a lack of demand. In 2014, shale production jumped by one million barrels a day. Compare this to the average yearly growth in global supply of 780,000 barrels per day since 2005 and one can clearly see how the supply-demand dynamics have been affected.

However, the supply surge may peak soon according to DBS analyst David Carbon. In a recent research note he writes: "The US EIA estimates that the boom in shale oil production will, for all intents and purposes, end in 2016. Even before the plunge in crude prices, production growth was expected to drop by more than half in 2015 and by more than half again in 2016. By 2017, shale oil production will stop rising. By 2020, it (and total) production will be falling again. US shale oil will remain an important source of supply in 2020. But on the margin, the surge in US supply will be gone by 2016." Further, in 2014, Asian demand absorbed sixty percent of the surge in US supply. In 2015, it will ‘absorb’ 135 percent of it. The demand-supply gap will have reversed, according to DBS.

With oil prices plummeting below $50/barrel, the question on everybody's mind is when OPEC will cut back on production. Till now, countries such as Saudi Arabia have been reluctant to do so as they wanted to maintain their market share and wanted to test just till what price level would "shale economics" be feasible.

Recent trends suggest that we will have answer the above questions quite soon. US drillers have taken a record number of oil rigs out of service in the past six weeks as OPEC sustains its production with Brent crude prices hovering well below $50/barrel. According to Bloomberg, the oil rig count has fallen by 209 since Dec 5, the steepest six-week decline since 1987. The count was down 55 this week to 1,366. Further, horizontal rigs used in U.S. shale formations that account for virtually all of the nation’s oil production growth fell by 48, the biggest single-week drop. Clearly, low oil prices are testing times for the US oil production.

Nobody complained about the fall in energy prices as it is largely a net positive for the global economy, even taking present deflationary pressures into account. A sharp recovery in energy prices would surely dampen the bullish outlook on global equities, especially oil importers such as India.

By: Vatsal Srivastava