July 6th, 2016

Oil prices: headed for a Goldilocks scenario?

by Enrico Colombatto After getting burned for years, many economists […]

Team AEC

After getting burned for years, many economists are reluctant to make predictions about oil prices. This report argues that crude is bound to stabilize somewhere between $50 and $60 per barrel. Volatility will still be acute, but the dynamic of supply and demand is now clear enough and unlikely to change in the near future.

If prices do stabilize not far above today’s relatively modest levels, a number of important geopolitical players will benefit, including Western Europe, China and India. Russia will see the end of its recession, and perhaps President Vladimir Putin will no longer need to stoke international tensions in order to bolster his prestige at home. A context featuring stability will encourage investors to be less cautious and more willing to engage in long-term entrepreneurial projects. Worldwide growth would be enhanced.

Of course, one cannot rule out political tensions in key oil-producing areas such as the Middle East. If this happens, one can only hope that any disruptions are limited and do not provide a pretext for intervention by major powers intent on expanding their spheres of influence.

Stability factors

During the past few weeks, despite the thrill generated by Brexit, crude oil prices have recovered and now hover close to the $50 mark, roughly their level a year ago. Could we be headed toward another period of instability, not unlike what happened in late 2015 and the early months of 2016? What seems more probable is a period of relative calm. Why this is so and the probable consequences are outlined in the rest of this report.

By and large, oil prices change in response to three sets of variables: supply shocks, demand dynamics and changes in the geopolitical situation. According to most analysts (including the International Monetary Fund), a significant increase in supply accounts for most of the price drop that occurred in the second half of 2014, after several years in which oil prices were close to $100 per barrel. Apparently, last year market operators and oil experts suddenly realized that new drilling and mining projects were about to become operational, and that there were not enough buyers to meet the surge of supply that was about to follow.

Of course, slow economic growth in the developed world did not help. Following this logic, the recent recovery in oil prices has been caused by a realization that perhaps the decline had gone too far, along with the idling of significant production capacity as a number of oil producers went bust, reduced output, or delayed plans to expand future output. All of these developments were particularly evident in the United States and in the non-OPEC area.

Supply and demand

Certainly, nobody has a crystal ball to tell where oil prices will be two or three years from now. Most forecasters who thought they did know have now learned their lesson and taken a more prudent view. However, two general facts seem rather clear.

First, supply and demand in the oil market have more or less stabilized. On the supply side, the world is awash with oil. Yet, it is also clear that producers are reluctant to start operating and exploiting those reserves until the price of oil makes a sustained break above $70 per barrel, and possibly even higher (for many recently developed fields the breakeven point is somewhere between $60 and $70 dollars per barrel).

On the demand side, the outlook for growth is relatively modest – about 3 percent worldwide and 2 percent in the OECD area. Global economic performance is unlikely to improve dramatically in the near future, but it is also unlikely to deteriorate, since its major drivers – China and India – are doing well.

Regional effects

Future scenarios will therefore depend on how the various actors adjust to the new context, which in the absence of major technological breakthroughs could be characterized by stability: slow growth in world demand matched by prudent behavior by suppliers, irrespective of occasional deviations. Three key geographic areas deserve special attention: Western Europe, Russia and the large, fast-growing developing economies – China and India.

Under the stable conditions described above, Western Europe would benefit from relatively low energy prices and its economy would continue to be sustained by cheap oil, which is both a blessing and a curse. It is a blessing, because if crude were to climb toward $100 a barrel, growth would be stagnant, leading to a buildup of fiscal and political pressure in a number of countries. At that point, money printing by the central bankers would not suffice to save Europe’s fragile financial sector. However, cheap energy might also be a curse, because the oil bonus gives politicians an excuse for inaction in countries that need comprehensive reforms.

In Russia, moderate oil prices will be an unqualified blessing, both for the Russians themselves and for the rest of the world. Fifty dollars per barrel is approximately the price Russia needs to balance its scaled-back state budget and pull out of recession – gross domestic product contracted by 3.7 percent in 2015 and is expected to drop another 1.1 percent this year. If the price of oil reached $60-$70 per barrel, Russia would be relatively healthy again. President Putin could claim that his decision not to cut production in the past 12 months had paid off and that Russia had overcome the sanctions. Inflation would also be easier to curb, given the reduced need to print money to finance the budget deficit and an increased appetite for Russian treasury bills among foreign investors.

In short, with oil prices stabilized above $60 a barrel, Mr. Putin’s domestic position would be enhanced and his need to flex muscles on the international scene would be correspondingly reduced. Moreover, it is worth noting that an oil price below $70 a barrel would not generate enough revenue to pay for overly ambitious international adventures. As in the recent past, carefully targeted and limited military intervention (as in Syria) would take precedence over more sweeping aims of regional hegemony (as China is trying to achieve in some areas of the African continent).

China and India are a different story. Since both of these countries are large oil importers, they would probably feel comfortable with oil prices no higher than $60 a barrel. According to the market forecasts this is a price level that would allow China’s economy to grow at a rate of 6.5 percent this year, and India to grow by 7.5 percent. Stable, moderate oil prices would give the authorities in Beijing extra time and resources to manage the economic transition in key industries (for example, banking and real estate) and would also help India avoid current account imbalances as its export industries fend off fierce competition from a number of Southeast Asian producers.

Global win-win

To summarize, market forces appear to be pushing us into a period of relatively cheap oil. There may be bouts of high volatility, as is often the case in commodity markets. However, major price moves into higher or lower ranges (say, below $30 or above $100) are unlikely, for two reasons.

Firstly, growth in world demand for oil will be restrained by sluggish economic growth, gradual technological improvements in fuel efficiency, and increasing use of competing sources of energy, including renewables. Secondly, the world is not short of oil, which imposes an upper limit on its price. At the same time, producers have learned their lesson and will think twice before increasing capacity whenever prices inch higher. This will help keep prices from falling for extended periods of time.

An environment of stable, moderate oil prices would be a win-win game for most major geopolitical players. Some would continue to benefit from affordable energy, while others would receive sufficient revenue to defuse tensions at home, but not enough to plunge into aggressive foreign adventures. Stable oil prices would also be welcome to most businesses and investors, because they make it easier to plan for the long term.

This does not exclude very different scenarios, especially if geopolitical tensions grow more acute in major oil-producing regions – especially the Middle East, Nigeria and Venezuela. In that event, uncertainty would make a comeback and market volatility would soar. This, in turn, would amplify the scope for all kinds of political intervention – whether to secure oil supplies if the output of a major producer is disrupted, or to enforce discipline should producers rashly flood the market to reap short-term gains.