London — Oil prices are no longer particularly cheap by historical standards.
Perceptions about prices tend to be over-influenced by recent experience so current prices feel very low to producers used to receiving $60-80 per barrel over the 2018/19 period.
But over a longer time horizon, current prices are not especially cheap, and are only a little below long-run averages over the last few price cycles.
Current Brent prices at just over $40 per barrel are in the 49th percentile for all months since 1988, after adjusting for U.S. inflation.
If prices were to settle at this level through the end of the year, the annual average would be just over $40, compared with an inflation-adjusted median of $50-55 since 1973.
The strong rally since April is a sign crude traders are confident about a sustained rebound in consumption over the rest of this year and that OPEC+ and U.S. shale producers will restrain output until excess stocks are absorbed.
As a result, the balance of risks has become more symmetrical than it was two months ago, when prices were clearly unsustainably low, which likely explains why the rally has lost some momentum over the last two weeks.
If the economic recovery and resumption in fuel demand proves more protracted, shale output does not fall as much as expected, or OPEC+ cohesion frays, price could pull back again.
But if a more optimistic scenario is realised (strong economic recovery, limited shale production, continued OPEC+ cohension), prices might continue to rise towards their pre-pandemic level of $55 or even $65 per barrel.
Oil prices are characterised by extreme volatility at all time-scales, but the trend has been down since the middle of 2014, mostly as a result of the delayed impact of the shale revolution in the United States.
U.S. production has grown faster than rivals’ output and global oil consumption every year since 2010 – with the exception of 2016, when prices crashed to an average of less than $50.
Shale production (the application of horizontal drilling and hydraulic fracturing technologies) has revolutionised and disrupted the global oil industry.
Like other transformative technologies, shale has had its main impact only after a long gestation. Horizontal drilling dates back to the 1980s and 1990s; hydraulic fracturing can be dated back even further.
The two technologies were first applied in combination to gas production in the late 1990s and early 2000s. Application to oil did not come until the late 2000s and they were not employed at significant scale until well into the 2010s.
In terms of growth, shale only became significant in the global market in the mid-2010s, when Lower 48 onshore production increased by an average of 1 million barrels per day each year between 2012 and 2014.
In volume terms, shale only became significant at global scale from 2014, when Lower 48 onshore output hit almost 7 million bpd, and continued climbing, up from just 3 million bpd in 2010.
Since then, shale producers have become the key price setters in the global oil market. OPEC+ continues to influence prices in the short run. But in the medium and long term the marginal price-setting barrel has come from the United States.
In the early 2000s, China’s extraordinarily rapid industrialisation led to an acceleration in oil consumption growth and a consequent escalation in real oil prices.
From 2014 onwards, however, real prices have been trending lower, largely as a result of the lagged effects of the shale revolution on production.
The five-year real price trend provides one way to “look through” short-term cyclical volatility caused by sanctions, volume wars and the business cycle to see the underlying structural forces shaping the industry.
Even before the pandemic, rapid shale growth had consistently pushed real prices lower. In the five years to December 2019, real prices averaged just $60 per barrel, down from $114 in the five years to December 2014.
In the medium and longer term, oil prices are being forced down to converge with the shale sector’s marginal cost, and empirically that appears to be around $60 per barrel.
Partly as a result, BP has reset its investment appraisal process on the assumption real prices will average $55 over the next three decades. Russia’s producers, too, seem to be preparing for prices in a similar range.
Real prices around $55-60 per barrel would be in line with the long-term median since 1973 (“Statistical Review of World Energy”, BP, 2020).
If prices cycled around this level, albeit with large temporary deviations, they would be cycling around the 52-58th percentile for Brent prices since 1988.
Real long-term prices at this level would be consistent with the post-2014 trend and are not obviously unreasonable.
In this year’s oil price outlook survey, conducted in January, before the coronavirus epidemic spread outside China, most respondents predicted prices would average around $65 through 2024.
From more than 1,000 responses, the inter-quartile range was $60-75, not very much higher then BP’s new investment appraisal assumption.
In practice, average prices could be higher or lower than $55 or $60 per barrel over the next few cycles, with the balance of risks appearing roughly even.
Some analysts and investors question whether shale producers have really been able to cover all their costs and operate profitably at prices as low as $60.
If shale has been systematically making losses, and investors insist on stricter capital discipline in future, marginal costs might turn out to be higher, pushing global prices back up over the next few years.
Moreover, India and other large emerging markets might follow China’s trajectory of rapid industrialisation, causing a fresh acceleration in oil consumption and putting upward pressure on prices.
In the other direction, however, the accelerating transition to a lower carbon economy and energy system could start to have a material impact on oil consumption growth.
And shale production, which has so far been restricted almost entirely to the United States, could be applied more widely around the world to boost output from a range of fields and environments.
The long-term trend in oil prices will be influenced by all these factors, and more. But based on the production and price trends over the last five years, a baseline forecast around $55-65 is not obviously unsustainable.
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