Why Crude Oil Prices Haven't Gone Crazy

By Matthew Philips

The oil markets have plenty of reasons to be spooked. In Libya, home to Africa’s largest reserves, production has fallen more than 80 percent since militias seized control of the country’s biggest ports last summer. Most of Iran’s oil remains trapped as well. Sanctions aimed at punishing Iran for its nuclear weapons program have crippled its crude exports by 1.5 million barrels a day. Nigeria is in the midst of its worst oil crisis in years: Rising violence, plus rampant sabotage and theft, have knocked out about 300,000 barrels of oil output a day. In Venezuela, which has the world’s largest oil reserves, production has remained unchanged after years of underinvestment.

Political chaos and violence are keeping 3.5 million barrels of daily oil production off the market, according to estimates by Citigroup (C). With tensions heating up over Ukraine, pressure is building for Western countries to impose Iran-style sanctions on Russia, the world’s largest oil producer. That would likely send prices soaring and push Europe, which gets 30 percent of its oil from Russia, into recession.

Yet through all the turmoil, oil markets have been strangely complacent. The price of Brent crude oil, the most traded oil contract in the world, fell from $110 a barrel on April 24 to $107 on May 6. The past three years have been one of the most stable periods for oil prices in recent memory, says Eric Lee, an oil analyst with Citigroup. Last year marked the smallest range of daily price movements in more than 10 years, according to the U.S. Department of Energy.

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The oil markets remain placid because almost all the oil production lost over the past few years has been replaced by the U.S. shale boom and increased Canadian production. U.S. shale oil production started to rise quickly in early 2011, right as the Arab Spring was kicking off. Since then, daily oil output in the U.S. has climbed by about 3 million barrels, to more than 8 million barrels. Canada has added more than 1 million barrels to its daily oil output since May 2011. “North America’s shale boom has been a huge calming factor,” says Lysle Brinker, an oil analyst at IHS Energy. “Without it, we might be seeing $150 oil right now.”

It’s hard to overstate the impact that rising U.S. oil output has had on global energy trade. Imports now make up only 28 percent of all the petroleum the U.S. consumes, down from 60 percent in 2005. In 2010 the U.S. was importing about 1 million barrels a day from Nigeria; now it’s 38,000. Much of the oil the U.S. used to import now goes to Asia. That’s helped keep markets well-supplied and prices immune from turmoil.

This calm may not last. Over the next five years, the world could experience an oil glut followed by a shortage. According to the International Energy Agency, which tracks oil markets, oil output by non-OPEC producers will rise by 1.7 million barrels per day in 2014, while total global demand will grow by only 1.4 million barrels. That has a lot of analysts predicting a crash in prices.

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Underpinning this view is a rapid slowdown in China’s economic growth. For years, Saudi Arabia, as OPEC’s largest supplier, has had the most influence on oil prices, but some analysts believe demand from China now determines the price of oil. If that’s true, prices could drop sharply. Demand for oil in China has fallen for the past two quarters, including a 3 percent drop in the first quarter of this year, according to research firm Sanford C. Bernstein (AB). That marks the first back-to-back decline since the financial crisis of 2008-09.

U.S. crude stockpiles are near a record high, causing traders to cut their bullish bets on the futures market. Also, Libya is finally exhibiting signs of exporting again. Talks between Iran and officials from the United Nations Security Council, scheduled to begin on May 13, could result in the rollback of sanctions and increased exports of oil. Iraq is producing more oil than it has in 35 years. If this keeps up, then over the next two years, “You’re talking about prices in the low $70s,” says John Kilduff, a partner at Again Capital, a New York hedge fund that focuses on energy.

Longer term, the problem may be an insufficiency of oil. Crude is becoming much more expensive to produce. Major oil companies have increased spending on exploration and production by 14 percent a year since 2005, only to see their combined production fall. This has many big oil companies lowering their capital spending in 2014: ExxonMobil (XOM) has announced it will cut spending by 6 percent, Chevron (CVX) by 5 percent. Royal Dutch Shell (RDSB:LN) is looking to reduce spending by 20 percent this year. “Oil majors are being eaten alive” on exploration costs, says Steven Kopits, an oil analyst at Princeton Energy Advisors. Charles Maxwell, a veteran energy analyst, says that lack of spending today will eventually lead to higher prices. “That’s going to bite us big time,” he says. “2019 is going to be hell.”

Culled from Bloomberg News