Will oil touch $100 a barrel again?

It took the better part of a year but the production cut effected by the 14-member cartel, Organisation of Petroleum Exporting Countries (OPEC), in January is beginning to show results. Prices of the benchmark Brent grade crude have shot up by 36 per cent since the middle of this year and went within touching distance of the $65-a-barrel mark before retracing steps in the last few trading sessions. On Friday, Brent was trading in the $61-62-a-barrel range.

Exactly a year ago OPEC decided to take 1.2 million barrels a day off the market through production cuts in an effort to bring down output to around 32.5 million barrels a day. The cartel persuaded the 11 non-OPEC oil-producing countries led by Russia to cut collective output by 600,000 barrels a day taking the total to 1.8 million barrels, which was a big deal indeed.

This was the first time since 2008 that OPEC reached a consensus on cutting output and scepticism ruled as to whether the members would keep their commitments. Put it down to pressure on national budgets but the cartel largely abided by the agreement and the results are there now for us to see. What the production cuts did was to take off the surplus inventory floating around, literally, and brought balance into the market.

The squeeze coincided with a revival of demand. With global economic recovery and consistent demand from Asia, especially China and India, the oil market began to feel the effect of the supply cuts. Geopolitics, as much as fundamental demand-supply equations, is a major factor in oil pricing, and the recent events in Saudi Arabia’s domestic politics coupled with the ongoing war in Yemen ensured that sentiment in the oil market would turn bullish on prices. That, in short, is the story of the current spell of elevated prices.

The important question now is: Is the oil market headed back to the era of $100 a barrel?

To answer that we need to understand the role played by the shale oil industry in the US. It was the latter that ended OPEC’s party in 2014 by flooding the market with its output. What the massive flood of oil did was not just depress prices but also disrupt the market equilibrium that had prevailed since the formation of the OPEC cartel in the 70s.

Saudi Arabia with its massive reserves of 260 billion barrels and dirt-cheap cost of production was the traditional leader and swing producer with an output between 8 and 10 million barrels a day. The kingdom could influence prices by turning its taps on or off.

The US shale oil industry appropriated this role of swing producer in 2014. For the first time in oil market history, Saudi Arabia faced erosion of its pricing power.

As prices began to fall, shale producers invested in technology that would enable them to consistently bring down break-even level. From between $65-70 a barrel three years ago, the break-even level for shale oil has seen a steady fall, and if the chief of Pioneer Natural Resources Company, one of the biggest producers in the Permian shale oil basin (one of two big basins along with Eagle Ford) is to be believed, it is as low as $20 a barrel now! That should be real bad news for conventional oil producers.

Output from the US, including conventional oil, is projected to shoot past 10 million barrels a day in 2018 according to the Energy Information Administration, relegating Saudi Arabia to second spot. Rig count is consistently rising and so is the monthly output trend.

The US is expected to turn a net exporter of oil by 2020 riding on the back of a second peak for shale oil output. This has tremendous implications not just for the energy market but also for geopolitics, especially in West Asia.

So, where does this leave oil prices?

Opinion, as always, is divided, with traders projecting a pull-back from present levels. The CEO of Vitol, an important oil trader, believes that prices could retrace their way to the $45 a barrel level. Balancing this is the opinion of OPEC’s secretary-general Mohammad Barkindo, who believes that demand will go past 100 million barrels a day (from around 85 million now) by 2020 and thus keep prices elevated.

An important factor to be kept in mind amidst all this is what the IEA terms “electrification of energy” which is now on in full swing. The first impact is likely to be felt in the passenger cars industry where electric cars are being promoted in a big way. China has said that it will push for alternative fuel vehicles to account for at least a fifth of all vehicles sold by 2025. The UK would like all cars sold to turn electric by 2040 while India is working to a target of 2030. Given the increasing awareness of the ill-effects of environmental pollution caused by fossil fuels, more countries are likely to jump on the electric car bandwagon.

This has tremendous implications for the crude oil market as demand for transportation fuels could peak sooner than expected. To be sure, electrification of the auto industry is not so simple given the tremendous investments that have gone into setting up manufacturing facilities for conventional cars. There is also the question of job losses in the event of a major shift to electric vehicles.

But the broad direction is clear and it is only a question of the time-frame now. And then there is the worldwide shift to clean energy sources such as solar and wind for power generation which will cut into the demand for fossil fuel.

While these will determine the long-term price trends, in the short-term, it appears that prices will be capped at a maximum of $65 a barrel, mainly because shale oil is swinging in with its output.

The adherence to production cuts in the face of falling prices by both OPEC and non-OPEC producers needs to be watched closely. We have seen in the past how such agreements have proved short-lived as producers race to make up on volumes for what they lose on price.

In sum, the odds on a return of prices to the three-figure mark appear low at this point in time.

Unless, of course, a major geopolitical crisis breaks out somewhere in the world. All bets will be off then.