The recent events brought dramatic changes to the previous projections on the global oil market. On March 9 of 2020 the futures prices of oil tumbled by an astonishing 25% in one trading session setting a new record biggest daily drop within the last 30 years. The widely traded ICE Brent plunged as low as $34.36/b [OPEC, 2020]. A week after the decline pattern continued breaking the minimums of 2016 and reaching the levels of 2003 [Markets.businessinsider.com, 2020]. The dramatic decline of the oil price, however, was triggered at the meeting of the OPEC, on which Saudi Arabia and Russia, the two largest oil producers after the United States, failed to agree on production cuts [foreignpolicy.com, 2020]. The situation is exacerbated by the ongoing outbreak of Covid-19 pandemic, which by that moment was already widespread in Europe. The expected decrease of the global demand for oil caused a further deterioration of the investors’ expectations around the world driving the oil prices below the minimums of 2015-2016.
Taking into account the above mentioned events the OPEC lowered the global demand for oil significantly from 0.99 mb/d (million barrels per day) to about 0.06 mb/d [OPEC, 2020]. The supply side has also undergone revisions and throughout 2020, the non-OPEC oil supply growth projections were lowered by 0.49 mb/d to 1.76 mb/d. On the other hand, the supply from OPEC is expected to grow in 2020 by 0.03 mb/d to an average of 4.83 mb/d. The projected price response to the price decline, however, is different for every oil-producing country mainly depending on the costs of production. The production of oil in the U.S. is expected to keep increasing despite declining oil price causing the non-OPEC supply to grow. Therefore, in order not to increase the global oil stock in 2020, the OPEC needs to cut its supply by at least 1.17 mb/d. However, it is clear that real changes in the demand and supply balance in order to drive the prices upwards require much larger cuts in production.
We should also bear in mind that the new OPEC report is very likely to differ from the real situation in 2020. The global spread of the Covid-19 and associated radical measures taken all over the world and most importantly in main oil-consuming countries will probably decrease the demand beyond the expectations. The report also clearly envisages a further tendency towards the weakening of the OPEC as the oil production in non-member countries, mainly in the U.S., keeps increasing. Thus, looking at the figures of the report we can see that during 2010-2020, the combined share of OPEC in the oil market has decreased from 34% to 28.2%. Advances in technology and the rise of shale oil production played a great role in reducing the power of OPEC.
| Figure 1. Oil price projections by World Bank and IMF vs actual average prices | |||||
| World Bank | IMF | Actual average annual price | |||
| Projected price | Percentage error | Projected price | Percentage error | ||
| 2012 | 89.7 | 4.6 | 91.9 | -2.3 | 94.05 |
| 2013 | 87.1 | -11.1 | 91.0 | -7.1 | 97.98 |
| 2014 | 80.4 | -13.7 | 86.6 | -7.1 | 93.17 |
| 2015 | 54.7 | 12.3 | 83.7 | 71.8 | 48.72 |
| 2016 | 44.8 | 2.8 | 94.5 | 116.8 | 43.58 |
| 2017 | 57.5 | 13.1 | 111.4 | 119.1 | 50.84 |
| 2018 | 62.9 | -3.1 | 111.2 | 71.3 | 64.90 |
| 2019 | 61.0 | 6.9 | 110.2 | 93.2 | 57.05 |
| Source: Prepared by the author based on data from World Bank, IMF, and macrotrends.net | |||||
It is natural to expect growing concerns over the oil prices among OPEC member-states as well as other oil-exporting countries. Given that the oil market responded to the lack of cooperation among major oil exporters and that leading European oil importers are being ravaged by the Covid-19, it is reasonable to expect further downward pressure to the oil price. However, the past records of the oil prices under certain market conditions and the quality assessment of the forecasts of oil prices give reasons not to accept price scenarios with certainty even when a situation seems very clear. For instance, annual forecasts based on sophisticated techniques by international organizations like the World Bank, the IMF or others often differ a lot from real prices that happen to be reached afterward. As we can see it from Figure 1, the error margins of annual price forecasts made at the beginning of every year might be over 100% in some cases.
The dynamics of oil prices are one of the most popular topics studied scientifically and despite all efforts, there has not been found highly efficient techniques that would be valid during long periods. During the rush of the oil market that lasts from the early 2000s to 2008, it was very common to refer to a belief that oil prices would go up forever and it was based on a simple understanding that oil deposits were subject to scarcity [Krautkraemer, 1998]. It can be said that market-induced price shifts not caused by rising costs, stimulate processes such as geological exploration, research, engineering, financial assistance, well drills, etc., which eventually increase the market supply of oil [Mossavar-Ramani and Denton, 1977]. There is a tremendous amount of studies and efforts devoted to unraveling the mechanism that determines the oil prices. However, frequent failure of these efforts makes it more likely that the oil market has undergone structural transformations that turn any relevant model in shorter-term perspectives obsolete for predictions during longer periods [Fattouh, 2007]. Moreover, the recent rise of shale oil production by the U.S. shows that technological advance supply of oil is very dependent on technological advance rather than the amounts available for extraction.
It is reasonable to expect prices to respond to the changes in global oil stocks, which is an accurately calculated indicator. Figure 2 depicts the price movement and the change of oil stocks since 1999. We can observe that the negative growth of global oil stocks during six years in a row from 2006 to 2012 was accompanied by high oil prices. Throughout 1999-2018, large declines and rises of oil stocks indeed caused opposite price movements. For instance, the correlation coefficient between the two indicators during 1999-2018 is 0.046, which shows a reasonable negative relationship.
Comparing fundamental factors of demand and supply in the oil market with the price change, we can note a huge difference between the volatilities. For instance, during 1999-2018 the maximum change in average annual oil demand and supply was 3.5% and 4.7% respectively. On the other hand, the average annual price could change from year to year by more than 50%. Despite the big price volatilities of the oil price, the year-to-year changes in demand and supply in the market were very small and never reaching 5%. The most straightforward explanation for markets’ overreaction to fundamental factors is the share of speculations in the market. This is also a widely discussed issue among researchers and the ultimate unresolved question in this kind of study is – how significant is the role of speculations in determining the market price of oil. It is important to bear in mind, however, that one cannot disregard completely the role of the fundamental factors that ultimately shape the price trends in the long-run.
The oil market projections for 2020 give reasons to expect a downward trend of oil prices with increasing production and shrinking demand. The latest OPEC forecasts suggest a 2.7% increase in production and a near-zero increase in demand. The ongoing slowdown of economic activity all across the world is another serious negative factor for oil exporters. However, we should bear in mind that fundamental market factors are not the ultimate source of price trends and speculative activities and investors’ expectations might act as pro-cyclical as well as anti-cyclical forces.
References:
Fattouh Bassam (2007). The Drivers of Oil Prices: The Usefulness and Limitations of Non-Structural Models, Supply-Demand Frameworks and Informal Approaches. Retrieved from https://www.econstor.eu/bitstream/10419/44880/1/539673587.pdf. Accessed on 19.03.2020.
Foreignpolicy.com (2020). Why This Oil Crash is Different. Retrieved from https://foreignpolicy.com/2020/03/09/opec-russia-shale-oil-price-collapse/. Accessed on 20.03.2020.
Krautkraemer, Jeffrey (1998). Nonrenewable Resource Scarcity, Journal of Economic Literature (36), pp. 2065-2107. Retrieved from https://econpapers.repec.org/article/aeajeclit/v_3a36_3ay_3a1998_3ai_3a4_3ap_3a2065-2107.htm. Accessed on 19.03.2020.
Macrotrends.net (2020). Crude Oil Prices – Historical Annual Data. Retrieved from https://www.macrotrends.net/2516/wti-crude-oil-prices-10-year-daily-chart, Accessed on 19.03.2020.
Markets.businessinsider.com (2020). Oil Tanks to Lowest since 2016 as Coronavirus Weigh on Demand — and It Could Fall Further as Crude Supply Faces a Record. Retrieved from https://markets.businessinsider.com/commodities/news/oil-price-fall-lowest-2016-coronavirus-supply-record-price-war-2020-3-1028999377. Accessed on 19.03.2020.
Mossavar-Ramani and Jesse Denton, (1977). On the Theory of Crude Oil Prices—II. Price Elasticity of Crude Oil Reserves, Energy Conversion 17 (2–3), pp. 85-95. Retrieved from https://www.sciencedirect.com/science/article/abs/pii/0013748077900791, Accessed on 19.03.2020.
OPEC (2020). Monthly Oil Market Report – March 2020? Retrieved from https://momr.opec.org/pdf-download/. Accessed on 19.03.2020.
Note: The views expressed in this blog are the author’s own and do not necessarily reflect the Institute’s editorial policy.