With Brent crude at just under $80 per barrel and WTI at $75, all eyes are on the upcoming OPEC meeting in Vienna this Thursday. The group may agree to cut supply in an attempt to give oil prices some support, but according to Societe Generale head of oil research Mike Wittner, there is a real chance that Saudi Arabia will let market forces determine oil prices for the first time, radically changing the oil industry.
“What makes this correction different – and make no mistake, it is very different – is that the root cause of the oversupply situation is not temporary at all. We believe it is a structural change in the oil markets,” says Wittner in a recent white paper. “This is what has people in the oil markets – producers, consumers, refiners, and investors – very focused. We believe that we’re in the middle of a very fundamental change in the oil markets – the type of change that only happens every decade or two.”
American shale and decreased disruption caused the oil price shock
Wittner explains that US shale oil has been on the rise for a couple of years now, but that disruptions elsewhere offset those gains – most notably fighting in Libya and sanctions against Iran. But the situation in Libya, while still not exactly stable, seems to be calming down, and talks with Iran have been extended another seven months which could bring more Iranian oil to the market as well. Add in weak demand as many economies still have yet to fully recover from the financial crisis and the result has been a serious shock instead of the gradual adjustment period the industry might have had under different circumstances.
If this were a normal market correction you could count on Saudi Arabia to take the lead in reducing supply, convincing other OPEC nations to cooperate as much as possible, and oil prices would stabilize. That’s still Wittner’s base case, he puts it at 60%, but he says that it’s also very possible that Saudi will decide that competing on volume and market share is in its long-term best interests. Since Saudi Arabia has a lower cost of production than anyone else, they are in a better situation to sit back until uneconomic production starts to come offline. This would be a major change for an industry that has always relied on Saudi Arabia to make sure that prices don’t go too low.
But Wittner says that would still mean a couple of years of $70 Brent and $60 WTI crude. If you’re trying to decide whether to start a new project, you have to look at the full-cycle cost of production, but at long as oil prices cover operating expenses existing supply isn’t going to get shut down. US shale oil would be the first hit by lower prices because of its shorter production cycle, but even then prices wouldn’t start coming back for a couple of years.