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Over the past five years crude oil has had a fairly turbulent time, we saw prices crash to $30 after the credit crisis and rise back up to $120. The recent decrease in the oil price by around 15% to $100 a barrel (Brent) poses the question, will oil fall further?

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Source: FT.com/markets

Crude oil is traded on the futures exchange in monthly contracts. We all recognize there is a relatively finite amount of oil on planet earth, and as such generally the futures curve is in contango. However the fine balance between supply and demand has caused crude to shift into backwardation.

Source: RBS bank (markets)

The recent drop in Brent crude from $118 a barrel may not have come as surprise to many as the futures contracts were pricing in Brent crude at $88 over the long term as shown above. This is down for a number of reasons.

A fall in demand

Half of the story why oil futures are in backwardation is that we have seen a slight slowdown in demand over the past year as anemic global economic growth has hampered progress. As shown below, China, the Middle East and Latin America have had the largest areas of growth and this is expected to continue as infrastructure spending especially in China will increase the accessibility for cars. China has a large capacity for growth in demand especially via the auto industry. For example, the average American uses 17 barrels of oil per year, whereas currently China uses two. The number of cars per 1000 in the U.S. is a massive 800 compared with 70 in China.

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Global demand is still growing, however this is dragged up by Non-OECD countries. Europe is the main area which has dropped as peripheral countries are enduring continued recession, which looks to remain for the near term.

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An Increase in Supply

As many will know, U.S. shale oil and gas are playing an important role psychologically in the minds of investors and it has already started to result in supply-side increases. Shale has been around for a number of years, however extraction required the technology and costs to facilitate it. As crude oil rose above $100 a barrel a vast amount of investment has been made into bringing some of the largest shale wells online in the U.S.

The U.S. made up 100% of Non - OPEC supply growth in 2012, and this is forecast to be around 80% this year.

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A majority of new fields however are deepwater as 83% of easily accessible major oil fields are past peak production (IEA Jan 2013). The demand for increased technology required in extraction is increasing as a result and companies such as Halliburton (NYSE:HAL) are well positioned to capitalize on this. However, it begs the question whether this increase in supply will have a significant effect over the longer term?

The IEA (International Energy Agency) estimates that global oil production will decline at 2-5% per annum over the next decade. The recent IEA forecast for 2013 crude oil demand highlights the long-term impact of decline rates. They recently revised demand increasing by a 'subdued' 795,000 barrels a day or 0.9%, to 90.58 million barrels a day. The net effect on global supply (on the lower end of the decline rate forecast) is -2.9% (not including new wells brought online).

The costs to extract shale oil is estimated to be between $50-70 a barrel (not including initial infrastructure costs), leaving a fairly poor margin on $100 Brent and $88 WTI. This is up against Saudi oil that costs just $25 a barrel. Many have claimed the shale revolution will make the U.S. a net exporter of oil. This is certainly a fantasy and although shale looks to add up to 4.5m barrels a day (top estimates) at its peak production towards 2020 there will be many obstacles to overcome. Shale has a high decline rate and requires a large number of wells to be drilled in order to access the oil. This will provide further support for the services industry, but questions again the costs involved.

If the price of oil does fall below $80 a barrel, this may start to affect future well drilling and production as costs may not be sufficient, further tightening supply.

It is evident that global supply remains tight and the price of oil is finely balanced, any decrease below $80 would limit supply further. This provides a level of support to the price at this level over the long term.

Whilst long term I expect the price of oil to rise, it is evident in the near-term production will be at a surplus and the price of oil will have limited upside potential.

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Long-term prospects are attractive and at current levels presents an interesting opportunity. The futures market is very pessimistic about demand and optimistic about supply, pricing long-term oil at $88 (Brent). Supply side constraints are understated and even if demand remains constant or at low level growth, any fall in supply (overestimated shale oil production) would push crude oil prices higher.

Source: Crude Oil: Has The Market Priced It Correctly?