Often the most important turning points in markets, and in this case the oil market, happen with a whimper rather than a bang. The ongoing crash in the oil market is mostly associated with OPEC’s fateful 2014 Thanksgiving Day decision to abstain from a production cut, thus sending the oil prices tumbling down by close to 10 percent in a single day. This was perhaps the price turning point, however this wasn’t the fundamental turning point, the latter goes back to August 2013.
First, let’s set the stage. For decades, the oil market operated under a simple formula:
(Global oil demand) – (non-OPEC supply) = OPEC production level (Call on OPEC)
Put simply, OPEC acted as a safety valve, it released the valve when there was growing demand or a major supply outage, and restrained it during periods of sudden demand weakness such as global recessions. The formula worked, because for the most part, non-OPEC supply wasn’t growing sufficiently to meet demand growth, this in turn gave OPEC the upper hand in dictating a given level of global oil supply.
The emergence of shale oil in the United States as a viable supply source earlier this decade changed this stable relationship.
As can be seen from the above, Non-OPEC supply held at a around 52.5m barrels for the three years prior to the oil crash, from 2010 to 2013. Then something happened. Non-OPEC supply leaped forward by 2m barrels in 2013 and by another 2.5m barrels in 2014. This begets an important question: Why didn’t oil prices tumble in 2013? Why did it take until late 2014 for the market to take note of this sizable underlying shift in non-OPEC supply?
This associated graph details YoY growth in monthly global oil demand, monthly OPEC and non-OPEC supply. Analyzing this data yields some fascinating results, and offers potential insight on where the oil market could be heading.
The first 12 months of the graph (Year 2013) demonstrates that non-OPEC supply mostly lagged global demand growth until August 2013, with the exception of two months, May and June. In August 2013, something changed, non-OPEC supply growth exceeded global demand growth and never looked back for 22 months straight. A highly unusual occurrence, yet, this fundamental change in the supply-demand relationship went largely undetected due to production declines at OPEC at the time (mostly due to production declines in Libya and Iran). This fragile balance finally broke down in September 2014, once OPEC resumed its production growth. This on top of much sustained non-OPEC production growth finally overwhelming global demand growth. This can be seen from the black line (global supply) breaking decisively above the purple line (global demand).
Looking at this, it is safe to conclude that oil prices were artificially maintained at the $100 level for most of 2013 and 2014 due to involuntary production declines at OPEC masking the extent of the imbalance between price sensitive non-OPEC supply and demand growth.
Non-OPEC supply stalls
After spending 22 months running ahead of demand growth, something happened in June 2015, Non-OPEC supply lagged global demand growth and has done so ever since. This fundamental shift has gone largely unnoticed due to a material increase in OPEC’s production in 2015 and 2016. What’s key to understand is that the majority of the increase in OPEC’s production was largely a one-off event.
During 2015 and 2016, OPEC raised its production by 2.12m barrels from 30.4m to 32.52m (as per EIA data). 84 percent of the increase or 1.77m barrels came from only two countries: Iraq and Iran. The exceptional increase in Iraqi production was due to large IOC investments undertaken before the crash (2011 to 2014) maturing in 2015. Meanwhile, the increase in Iranian production was due to the removal of the nuclear sanctions in January 2016.
The increase in Iranian production last year was especially significant in masking the extent of non-OPEC declines. In 2016, OPEC production increased by 890K barrels, 690K barrels of the increase came from Iran. Absent an increase in Iranian production in 2016, the oil market would have been materially undersupplied.
What’s next?
Due to the factors discussed above, the market has been under the impression that $50 oil is business as usual, just as the market was deceived into believing that $100 a barrel was business as usual in 2013, and for most of 2014. To truly gauge the oil market ability to balance at a given oil price, one must adjust for geopolitical changes in OPEC’s supply. Undertaking this exercise clearly indicates that a triple digit oil price is not sustainable due to its negative impact on demand growth and its overstimulating impact on Non-OPEC supply. Meanwhile, it is also clear that current oil prices are too low as evident from demand growth exceeding non-OPEC supply for the last 20 months and counting.
For current prices to sustain, OPEC must continue to fill the growing gap between non-OPEC supply and global demand growth. In light of the one-off OPEC supply factors that have taken place over the last two years - the ongoing OPEC cut not withstanding - its questionable that OPEC will be able to grow its production at the same brisk rate it did in 2015 and 2016 for any length of time (OPEC capacity growth will be the topic of my next article.)
With OPEC holding its production flat, a major turn in oil prices appears imminent, and could potentially carry prices to the $60-$70 range once the market takes notice of non-OPEC’s supply inability to meet demand growth at current prices.
By Nawar Alsaadi for Oilprice.com
