Economics 101: Oil to Go Higher

January 16, 2015 • Education • Tags:

The International Energy Agency (IEA) released a report earlier this morning stating that it sees a rebound in oil prices in the latter half of 2015. Currently, oil prices are trading around $48, but this depressed level will be short lived. Here’s why.

Factors Influencing Higher Demand

If oil prices continue to remain low, economies will grow faster as consumers spend less at the gas pump. The savings are essentially a tax-cut which creates excess discretionary income for consumers. Cheaper oil prices will encourage demand as the economy grows, helping lead oil prices higher. This is evidenced by auto companies such as General Motors and Ford reporting big increases in SUV sales in the last quarter as people look to take advantage of low oil prices.

Supply Glut to Be Trimmed

Several smaller oil producers have shut down operations, while larger ones have significantly cut capital expenditures or delayed new projects. For instance, big name players such as Statoil (STO) and Royal Dutch Shell (RDS) have slashed their capital expenditure budgets. Statoil cut $1.3 billion in costs per year starting in 2016 while Shell cut its capital expenditure budget down 20% for 2014 and scrapped its $6.5 billion al-Karaana project with Qatar Petroleum in Qatar. In Canada, Cenovus Energy (CVE) cut its 2015 oil sands budget by 15% to between $2.5 and $2.7 billion while Husky Energy (HSE.T) is reducing its spending plans by $1.7 billion in 2015. Capital expenditure cuts and project slowdowns will decrease the supply glut over the long term.

Moreover, the IEA downgraded expectations for non-OPEC supply growth in 2015, with growth for the year adjusted downwards by 350,000 barrels per day since its December report, with Colombia and Canada leading the declines. With increase demand and lower supply (compared to today’s high supply levels), oil prices are bound to increase from its current levels.

A Deutsche Bank study in October 2014 suggests that oil producing countries and OPEC have significantly higher breakeven prices for crude oil, especially when it comes to balancing their fiscal budgets. Saudi Arabia needs a breakeven of around $99 to support its fiscal spending, although they have higher reserves that enable overspending in the short term (unlike Russia and Venezuela) and extremely low production costs in the mid teens per bbl of crude oil. Saudi Arabia’s current focus is on keeping their market share in the oil industry as the US shale production continues to ramp up. This is a primary reason why Saudi Arabia is striving for a lower oil price as the production costs for Saudi Arabia is approximately $15-20 per bbl whereas shale oil production costs in the United States is in the mid to high $40s. Even on an adjusted basis, taking currency effects into account, the breakeven price of oil for OPEC countries is $72.

Oil Prices
Where do you see oil prices in 12 months?

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