More Upside than Downside in Oil by Jon Ruff, AllianceBernstein
A combination of factors has driven oil prices down since midyear, and while oil prices could fall further in the next couple of months, we think they’re likely to rebound in 2015. If they don’t, there could be an even bigger surge down the road.
The price of West Texas Intermediate crude oil has been cut nearly in half, from a high of $107 per barrel in mid-June to under $60 per barrel in early December. What’s behind the decline? Global demand has been weak, and supply has surged. We’ve seen a relentless rise in US oil production from shale oil fields. Saudi Arabia kept its production up as Libyan supply miraculously recovered amid a three-way civil war. And Nigerian production unexpectedly recovered.
The Short Term: Rebound Likely in 2015
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We expect the price of oil to fluctuate over the next few months as the market grapples with difficult-to-analyze issues. Options markets imply a 15% chance that oil will fall another $10 per barrel by early next year, but shale-cost economics and OPEC budget math should result in prices moving back toward $80 per barrel by the end of 2015.
Shale oil producers will delay projects if cheap oil makes them uneconomical. The lower the price, the more shale projects shelved—and the lower supply growth will be six to 12 months later. Few of the new shale wells planned for 2015 would break even economically at current oil prices (Display 1).
Falling costs and technological innovation may eventually reduce break-even points, but pricier financing has already raised them. The shale industry, on average, spends about $1.20 for every $1.00 of cash flow it earns. It makes up the difference through borrowing—often using high-yield bonds. The high-yield market, however, recognizes the risk from low oil prices, so the cost of financing has doubled in the past couple of months (Display 2)—if it’s available at all.
Major oil-producing countries could also bring supply discipline in 2015. Few of them can sell oil at $80 per barrel or less without running massive budget deficits or slashing spending. Financial markets will likely balk at growing budget deficits for countries like Venezuela, and social spending cuts could bring popular unrest. The short-term alternative: a shared production cut among OPEC members and possibly Russia. It’s in their interest to see oil rise above $80 per barrel in 2015.
The Long View: $150-Plus Oil Is Possible
If prices decline further this year and don’t rebound in 2015, prices could spike dramatically three to five years out. Lower prices would accelerate the trend of projects being deferred for economic reasons. To make up for this lost supply, we estimate that OPEC would have to dip into its spare capacity, pushing prices up and bringing deferred shale projects back on line.
If non-shale producers delay their longer-term projects for too long, even robust shale supply will struggle to meet demand five years out. As OPEC draws down spare capacity to dangerously low levels, even a minor shock could launch prices above $150 per barrel. If, on the other hand, geopolitical conditions prove calm, prices would still have to rise above $100 per barrel to compensate for the risk of a shock—and to attract enough investment to make up for years of underinvestment.
Risks to a Longer-Term Oil Price Increase
If oil prices don’t rise modestly in 2015, we see three possible risks to our view of a sharper long-term increase: First, sanctions on Iran could be lifted, with the increased supply delaying upward price pressure. Second, the Saudis and the rest of OPEC could decide that the best way to maximize their revenue over the long run is to produce all-out forever; we don’t believe that such a shift is in their interest. Third, technological innovation in drilling technology could continue to make exponential leaps forward. However, the investment behind this level of innovation is more likely to come in a high-price environment than in a low-price one.
The bottom line is that oil prices may be volatile over the next few months, but short-term downside risk is more than offset by longer-term upside potential. Long-term investors may want to consider adding exposure to long-term oil prices—either directly through long-dated energy futures or indirectly through long-horizon public and private energy equity.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Jon Ruff is Lead Portfolio Manager and Director of Research for Real Asset Strategies at AllianceBernstein Holding LP (NYSE:AB).