Making a case for oil price to drift upwards

World leaders met in Davos recently to discuss the biggest challenges facing the global economy in 2016, with the falling prices of oil, quite naturally, at the heart of their concerns.

The Forum took place on the back of news that the price of oil had hit its lowest level in over 12 years, extending its losses well into the new year and despite the fact that its oversupply started to decline in the latter half of 2015, the result of falling US shale output and resilient demand.

So while we continue to foresee an eventual oil price equilibrium at higher levels (around $55 per barrel), offset by the marginal cost of the US shale industry, it is difficult not to acknowledge that strong headwinds are blowing in the short term, in turn likely to fuel persistent volatility throughout the rest of the quarter.

Much of this can be credited to early December’s Opec meeting. Whilst we at Lombard Odier, and the market as a whole, had no strong expectations for any outcomes, the lack of guidance on a production quota underlined the clear discord between some of the country members, sending oil prices into free fall.

Saudi Arabia, as has been the case from the very beginning, holds the key to the pace of Opec supply. True, its 2016 budget did emphasise a commitment to fiscal consolidation, with a drop in the fiscal break even price from $106 per barrel to $96 per barrel. But there is no hurry to support the current price levels, and we compute that Saudi Arabia could maintain its current budget expenses for four years with our projected equilibrium ($55 per barrel) or three years around $35 per barrel.

Another negative outcome of the meeting was the absence of an agreement outlining the accommodation of higher Iranian production — with the decision deferred to its next meeting in June.

Visibility into its actual capacity varies wildly, meaning that related uncertainties will continue throughout the year. And given recent geopolitical escalation, we see little likelihood of Saudi Arabia limiting its own production so as to facilitate the return of its long-dated rival into the oil market.

All told, we would be very surprised to see the Opec bloc taking any drastic action to support current oil prices. ‬

The medium-term outlook paints a more positive picture. Despite the current concerns, we maintain our scenario of a gradual reduction in the supply glut, and an equilibrium price set by the swing producer — in this case, the marginal production cost of the US shale industry.

The longer the oil price remains low, the larger are likely to be the cuts in this sector’s capital expenditures and, in turn, US production (particularly since the shale industry investment cycle is rather short relative to that of its more conventional peers). With all that said, an important caveat needs to be made: the US shale industry has the ability to adapt very quickly, cutting costs significantly over the past year, and enabling most companies to continue to produce even at current levels.

As a result of this cost deflation, our projected equilibrium is lower than it otherwise may have been, at $55 per barrel.

Nonetheless, we still expect to see a significant decline in US shale oil output, potentially triggered by production shutdown announcements. This, coupled with resilient demand (US vehicle miles travelled, a leading indicator of US demand, remain at 10-year record levels) tell us that even though there may be some further downside in the near term, this is part of a broad bottoming process.

Oil should then be able to drift higher over the remainder of 2016, contradicting some of the pessimism that has come out of Davos recently.

The writer is Managing Director of Lombard Odier, Dubai.