How long will oil be cheap?

So, oil prices are on the retreat once again. After a heady February when the benchmark Brent crude posted its biggest monthly gain in six years gaining about a third to $60 a barrel, oil prices have turned soft again having lost about 8 per cent from last month’s peak. Interestingly, whether it was the rebound in February, the precipitous fall in the months running up to that or the retreat now, the market moving factor has been US shale oil output.

And thereby hangs the tale of a fundamental shift in the global oil industry dynamics. Saudi Arabia, the uncrowned king of the oil markets thanks to its huge reserves and status as the biggest oil producer, called the shots due to its ability to play the role of a swing producer — it could move the market and influence prices by turning the tap on or off at its free will.

But now, the US, thanks to its shale oil producers, may just have snatched that role from Saudi Arabia. And the US can play the role of swing producer to greater effect as shale oil output can be cranked up or marked down in quicker time than conventional oil. The present spell of soft prices is simply because the decelerating trend in shale oil output from September last year reversed in February.

So, are the good times set to continue for consumers and are prices likely to stay subdued in the months ahead? It is hazardous to venture predictions on oil prices; in fact, forecasting prices is next only to finding oil in the order of difficulty. That said, certain broad conclusions can certainly be discerned by studying prevailing trends in the market. And what are those trends?

First, there is still a situation of excess supply in the market estimated at around 1.5 million barrels per day.

Demand is improving as seen by Saudi Arabia’s decision to increase the official selling prices for April to customers in Asia and the US, but it is still not strong enough to sponge up the extra supplies, which is set to increase soon.

And that brings us to the second trend. The nuclear negotiations between Iran and the West are set to end later this month successfully and it is likely that sanctions on the country will be lifted allowing Iran to increase its oil exports.

This will mean additional oil of between 300,000-400,000 barrels flowing into the market adding to the oversupply.

Third, storage data in the US and in Europe are showing an increase which is a pointer to demand being soft. With prices for future deliveries quoting higher than current prices — what is known as “contango” in oil market jargon — traders are putting away stocks, including in floating storages, to capitalise in future.

Fourth, and most important, is the strength of the dollar and the possibility of interest rates beginning to move up in the US in the next three months.

Commodity markets in general and oil in particular are driven as much by speculative money chasing short-term returns as fundamentals.

Fund managers may well begin to shift some of their speculative interest to the dollar, which is likely to strengthen further on positive economic data, and to US Treasury bills, on the promise of higher returns.

These factors that are positive for a soft oil price regime have to be weighed against the fact that all indicators on the ground point to a sustained decline in shale oil output in the months ahead.

Unlike conventional oil wells, shale oil wells spew out large quantities of oil when they are new but the reserves start depleting quickly from the second or third year onwards and well yields start falling sharply.

So the trick is to consistently keep drilling newer wells to replace and add to the existing ones. Net output can be increased only if the production from the newer wells is higher than the decline in the older ones.

Recent data from oil services firm, Baker Hughes, show that the number of rigs in service in the US has dropped sharply to 1,192 from 1,792 a year ago due to the fall in oil prices. This indicates a fall in the number of new wells being drilled as prices turn uneconomical.

A number of shale oil producers have also been fed by cheap funds from the Fed’s stimulus programme which is not available anymore. This is exactly the scenario that Saudi Arabia was playing for when it refused to cut output in the second half of 2014.

The strategy was to get prices down to levels that would prove uneconomic for shale producers to get them out of the market so that prices can rebound.

If this is not enough, Big Oil companies such as BP, ExxonMobil, Chevron and Shell have all clipped their capital expenditure budgets; BP has shaved off as much as a fifth of its capex this year due to low oil prices. The impact of the spending cuts will begin to be felt from later this year in the market though for now these companies are managing to maintain their production levels.

And then finally, there is the ‘X’ factor that always plays a major role in the oil market — geopolitics. A rise in tensions in West Asia can affect production and hence prices.

In sum, therefore, the outlook for the near term appears good for consumers but prices may well begin to trend up in the later half of this calendar year.

Policymakers need to keep a close watch on how the oil market pans out especially because the numbers of the recent Budget are premised on oil prices remaining soft.

What the above also means is that the window of opportunity for the government to push through the remaining reforms on subsidy, especially in cooking gas and kerosene, is limited. It should hurry up before prices start trending upwards again.