I have been following the oil price crash since it began in late 2014, providing annual forecast scenarios and monthly vital statistics updates. There has recently been an acceleration in activity and news, and as the oil price has continued its fall to below $30, investors and speculators wrestle with the main question: "how low will the oil price go?"
In August 2015 I gave a crude answer to that question based on history in a post called The Oil Price: how low is low? where I observed:
To get straight to the point. Brent will need to fall below $30 to match the lows seen in 1986 and to below $20 to match the lows seen in 1998.
This observation was based on deflated annual average price from BP ($2014). The notion of $20 oil has since caught on and some commentators are now speculating that $10 is possible. It is time to have a closer look at what history tells us.
First a look at recent oil price action.
Figure 1 Long term picture of WTI and Brent daily spot oil prices. The most recent falls have taken the oil price to the 2008 lows that technically may provide price support. But supply demand fundamentals are against that. The last time we had an over-supply based rout was 1998/99 (arrow) where in money of the day, Brent bottomed at $10/bbl. Adjusted for inflation, that is approximately $15/bbl in today's money.
On a money of the day basis, the oil price has now reached the lows, and support level, seen in the wake of the 2008 finance crash. In detail, the support level has already been pricked and on a deflated basis, that support is already broken. The fundamentals of over-supply remain and so there is no reason to believe that the oil price crash will turn at this point. Seasonally, demand for oil is always weak in the first and second quarters. This alone will work against price recovery in the near term.
The IEA OMR for December 2015
The January OMR with data for December was published today and I've waited to see what it had to say before publishing this post. The main headline is that global total liquids supply was 96.88 Mbpd in December, down 90,000 bpd on November. This is effectively unchanged. The IEA observes:
a procession of investment banks has warned that oil prices "could" fall to $25/bbl, $20/bbl or, in one case, $10/bbl.
and asks the question:
Can It Go Any Lower?
So the answer to our question is an emphatic yes. It could go lower.
- Sanctions against Iran, as expected by all, have been lifted clearing the decks for full oil exports to resume. Recent estimates suggest an additional 500,000 bpd exports. In my Oil Price Scenarios for 2016 post I assumed 800,000 bpd additional oil from Iran. Regardless of whichever comes to pass, Iran returning to full exports makes the over-supply situation worse.
- Saudi Arabia has floated the idea of selling a 10% stake in Aramco, the Saudi State oil company. This confirms the precarious state of Saudi finances but also Saudi commitment to staying the strategic course. They would rather sell the family silver than back down from their course towards national ruin. Personally I don't believe this transaction will ever take place since investors will be buying into production and not reserves, in a Nation that lies at the centre of turmoil in the Middle East.
- The Chinese stock market has crashed again and looks like it could now head much lower leaving major questions about the general state of the Chinese economy. The engine behind the commodities super cycle looks like it may take some time out for repairs.
- BHP Billiton (NYSE:BHP), with Australian roots, listed in London but with global operations is one of the World's largest diversified energy companies with stakes in oil & gas, coal and uranium mining. They just announced a $7 billion write down on their US shale assets. With a market capitalisation of £36 billion, BHP can withstand balance sheet losses such as this more easily than the smaller shale players.
- UK North Sea oil production is rising for the first time since 1999.
- US oil and gas drilling rig count continues to fall steadily but not so steeply as during the early stage of the oil price crash. Below I take a closer look at the oil price crash of 1998 / 99. The chart shows that back then US operational rigs fell from 1000 to 500 before making a sharp recovery. Today, the oil+gas rig count stands at 650, not yet so low as 1998/99 but proportionally much lower since the drilling fleet size is now 2000. At least it was 2000 leading into the crash.
Figure 2 Stacked chart of US oil and gas directed drilling. The total rig count stood at 650 on 15 January, 515 oil and 135 gas. The combined rig count is still falling steeply and this must inevitably bring about more significant declines in US oil and gas production at some future date once the backlog of drilled but uncompleted wells works through the system.
The oil price crash of 1998/99
The oil price is already in irrational over-sold territory where virtually all producers are making substantial losses, be they fiscal losses in OPEC countries or economic losses in the market economies of the OECD. Longer term, the oil price must rise above the level where everyone makes money, but short term, economics is not helpful in trying to constrain where the market bottom might be. In the absence of any rational economic pointers, all one can fall back upon is what happened before during similar circumstances. The oil price crash of 2008 is not a good analogy, driven by financial crisis, that crash was ended with OPEC reining in production by 5 Mbpd. We have to go back to 1998 / 99 to see what happened during an oil market driven price crash.
In money of the day, Brent fell below $10 / bbl for brief spells during December 1998 and February 1999. Back then, WTI traded at a premium to Brent of roughly $1.50 / bbl. Today the WTI-Brent spread is effectively zero. Adjusting price for inflation using the BP deflator points to price lows of about $14 for Brent in 2014 dollars.
Figure 3 WTI and Brent daily spot prices as reported by the EIA in money of the day (MOTD).
Figure 4 Same as Figure 3 with prices adjusted for inflation using the BP deflator where $2014 = $1998*1.45. Note that the price defines a distinct double bottom.
It is important to note that the nature of the 1998/99 price crash was different to today's since this marked the culmination of an oil bear market that began in 1981. Today's crash is caused by an inelastic market constrained by production volume where relative swings in supply and demand of ±2 Mbpd is causing price swings of ±$40 per barrel. The market is currently caught in the over-supply + weak demand vortex.
Once in a decade buying opportunity?
It is important at this stage to note that I am not a qualified investment advisor. All I am doing here is laying out a framework of data and information to help others reach their own decisions.
There is no near-term bullish news for oil in the "Recent News" I recount above. With over-supply remaining, I therefore expect price to carry on down during the first two quarters. It is worth noting that $20 is still 50% below $30 - that is a long way down! But in the interim, distressed investors may be forced to sell on margin calls which provides fuel to the downward spiral.
My central scenario for Brent in December 2016 was $37. Other commentators see the price higher than that by year end. Should Brent go sub-$20 by mid-year this would clearly present a good investment opportunity if prices do indeed rise thereafter as expected. Of course, if one waits for sub-$20 and the price never gets there, that would result in an opportunity lost.
My gut feel is that market bottom will be in the vicinity of $15. There are two reasons for saying this. The first is that professional investment houses will to large extent be looking at the same data I am and if they reach the same conclusions, they will define the behaviour of the herd. The second is that current price trajectory heads towards $15 by the end of the second quarter. Beyond that, supply and demand should converge towards balance, heralding recovery.
In my 2016 scenarios, one scenario was called "Event" and the probability of an Event taking place, like disruptive terrorist attacks in Saudi Arabia, will increase as the price falls. For example, Saudi ability to pay for state security is impaired while the levels of social unrest linked to mounting poverty rises. If there is an Event that sends the oil price sky high then lucky investors will be those who got on board beforehand.