Oil is an inherently cyclical business. The point is remarkably simple but it is amazing how often it gets forgotten by forecasters and investors.

In the century and a half since the modern oil industry was founded with the drilling of Edwin Drake’s well in 1859, real prices have doubled in the space of three years on no fewer than six separate occasions, and halved on four.

If prices remain around $50 for the rest of the year, 2015 will be the fifth time real prices have fallen more than 50 percent in the space of less than three years.

Sharp price changes over short periods have therefore been the norm and the long period of relative stability between 1931 and 1969 was the exception.

It follows that any attempt to predict where prices will go in the medium term (two to five years) or long term (beyond five years) based on current prices or recent changes is bound to fail.

The cyclical, unpredictable nature of prices has not stopped an army of prognosticators from trying to guess where they will go, but most forecasts have an endearing backward-looking quality.

When prices are high and have been rising, most forecasts predict they will rise even further on increasing scarcity. When they are low and have been falling, most forecasts predict a further slide on continued oversupply.

In 2008, and again in 2011/12, as prices were peaking at more than $140 and $120 per barrel respectively, most forecasters were predicting prices would remain high more or less forever.

Not one major forecaster saw prices sinking back to less than $60 per barrel but on both occasions it happened in less than three years.

Now prices have fallen, it seems no major forecaster is predicting they will rise sharply again within the foreseeable future.

But the current bearishness about the medium-term outlook is no more likely to be accurate than the former bullishness was between 2008 and 2011.

CHANGES ALREADY UNDERWAY

Forecasters all make the mistake of assuming the medium term will look similar to the recent past whereas experience shows it will look very different.

Both supply and demand sides of the oil market are subject to long lags between price changes and adjustments in production and consumption.

The current production and consumption environment was shaped by prices over the last two to five years, between 2010 and 2014, when prices were generally high.

The supply and demand environment in two to five years time, between 2017 and 2020, will be shaped by prices now -- which are currently much lower.

Big changes are already underway. Oil consumption in the advanced economies this year is set to grow at the fastest rate for more than a decade as a result of the fall in prices and continued economic recovery.

On the supply side, non-OPEC production growth will slow from 2.4 million barrels per day (bpd) in 2014 and 1 million bpd in 2015 to zero in 2016, according to the International Energy Agency.

And after three years in which U.S. shale grew by more than 1 million bpd each year between 2012 and 2014, providing most of the increase in global production, shale growth is set to fall to zero in 2016, according to the U.S. Energy Information Administration.

With supply growing more slowly than before, and demand rising faster, the market surplus should be eliminated within the next 12-24 months if prices remain where they are currently.

Rapid growth in fuel consumption coupled with a sharp downturn in oil drilling around the world indicates the current price level is not sustainable in the medium term.

In practice, it is reasonable to assume prices will need to move somewhat higher than they are at present to moderate demand growth and encourage more investment in production.

ANOTHER LOST DECADE?

Some analysts and oil company executives believe the industry could be entering another decade-plus downturn similar to the one which occurred between 1985 and 1998.

But the comparison is not a good one because the current situation in the oil market differs from the 1980s and 1990s in important respects.

In 1985, the members of OPEC had around 10 million bpd of spare capacity, which took more than a decade to reduce to a more normal level.

In 2015, by contrast, OPEC’s spare capacity is less than 2 million bpd, according to U.S. Energy Information Administration estimates.

On the supply side, the 1980s and 1990s witnessed rapid growth in non-OPEC production from the North Sea and other areas, which has some parallels with the surge in shale supplies.

But shale production is more modular and sensitive to price changes than the huge conventional oil fields developed in the North Sea and other areas during the 1980s and 1990s.

There is no doubt the oil industry is going through a deep and painful adjustment after a decade-long boom.

But predicting that it will be as long and as painful as the downturn of the 1980s and 1990s would likely be another backward-looking forecast made in the aftermath of a price slump.

Source: www.reuters.com

Please leave comments and feedback below