The oil price has had a turbocharged run in the last year, rising almost 60%. Last Friday it closed at a three year high of $77 a barrel. From the, early 2016, lows of under $30 the oil price has risen by over 160%.
Three factors explain the rebound in oil prices.
First, the global economic upswing has come faster than expected fuelling demand for oil and bolstering prices. Despite a first quarter wobble, the global economy is likely to grow at the fastest rate in seven years in 2018.
Second, a 2016 agreement between OPEC and Russia to reduce output has helped work off a large amount of the previous glut of oil and has led to a tightening in the market. (This surprised me. I had thought that OPEC’s ability to get its members to limit output in pursuit of higher prices was weakened).
Third, geopolitical developments threaten supply. America’s withdrawal from the Iran nuclear deal and the re-imposition of sanctions, would hit Iranian oil sales. Yemen’s Houthi rebels, who are allied to Iran, have been firing missiles into Saudi Arabia, including targeting a supertanker carrying oil and oil storage facility on the Red Sea coast. A direct missile hit on Riyadh, or an oil facility, would represent a material escalation of the proxy conflict between Iran and Saudi Arabia. Meanwhile, Venezuelan oil production has fallen by a third since 2015, the industry a victim of the mismanagement of the nation’s economy and Libyan output, though recovering, remains well below pre-revolution levels.
In thinking about where prices are heading in the longer term we need to be wary of the tendency, at extremes in the price of any asset, to extrapolate recent trends into the indefinite future. When the oil price reached an all-time peak of $144 in 2008, the talk was of how declining reserves and endless demand from China meant permanently high prices. Instead prices collapsed.
The fundamentals of global oil supply have been changed by rising US oil production. Fracking has enabled US crude production to double in the last ten years, making the US the world’s largest oil producer last year. The global supply curve for oil has, in the jargon, shifted to the right.
In time, higher oil prices boost exploration and investment, just as the sharp decline in prices in 2014/15, hit investment. The number of rigs exploring for or developing oil or natural gas in the US and Canada has risen almost three fold in the last three years. Improvements in horizontal drilling and hydraulic fracturing have brought costs down sharply. The breakeven price for US frackers appears to be in the range of $50, giving them plenty of incentives to invest at current prices.
Global levels of capital investment in oil and gas have also been rising for the last year.
If I knew where oil prices were heading I’d be an oil trader, so what follows are guesses. Supply-demand dynamics and geopolitics point to upside risks to oil prices in the near term. But, on a one year view I think it’s more likely that softer global growth and increasing supply will drive prices below current levels.