Two separate reports from major investment banks over the past week put forward this argument. Bank of America Merrill Lynch predicts that medium-term oil prices will be “anchored” around $60 per barrel, explored in an article a few days ago. Barclays added its voice, largely coming to a similar conclusion.
The prediction of lower volatility may come as a surprise since the oil market is still reeling from the wild swings in 2018. As recently as the fourth quarter, Brent jumped to nearly $90 per barrel only to crash to around $50 per barrel in a matter of weeks.
But that doesn’t mean that head-spinning levels of volatility will continue. “Changes in the structure of supply and demand mean these gyrations in market prices will become less frequent, less intense, and less long lasting,” according to Barclays.
The investment bank says that this comes down to two underlying reasons. First, there probably won’t be any major imbalance in supply for the foreseeable future, at least not like before. Second, the elasticity of supply has increased significantly.
Let’s take the first point. The massive increases in production from U.S. shale, Barclays argues, has left the market with ample supply, and growth is expected to continue. Saudi Arabia has restored some spare capacity after the OPEC+ cuts. Brazil is expected to bring new pre-salt production online.
“Based on the number of projects started over the past few years, and our forecast for production coming from future projects, we think supply will easily meet demand,” Barclays said. “So, one reason prices should be more stable in the future, is that we just don’t see an upward surge in prices due to insufficient supply alone.” Prices should rise, but only modestly and slowly over time, the bank says.
That doesn’t mean that prices won’t rise at all. A few factors will drive prices higher in the years ahead. First, U.S. shale growth is expected to slow. Second, even though proven oil reserves have jumped by 50 percent over the past 20 years, from 683 billion barrels to 1,696 billion barrels, more than half of those are in “at-risk” areas, Barclays argues, “where extraction will likely become more expensive.” Finally, electric vehicles are set to set to eat into oil demand over time, but the investment bank doesn’t see that happening until the mid-2020s.
Ultimately, prices will rise in the years ahead, Barclays says, but not in a dramatic way. The gains are modest and not as volatile as in the past.
The second underlying factor for why volatility may diminish is because not only is supply rising, but the elasticity of supply is also increasing. This argument is not new. U.S. shale growth has exploded over the past decade and the one defining feature of shale is that projects are short-cycle, able to reach completion in a matter of weeks in most cases. Conventional projects, particularly large-scale projects, can take years to develop.
The short-cycle nature of shale means that output is much more responsive to price swings. When prices crash shale drilling slows pretty quickly, while the opposite is also true. Moreover, because shale continues to capture a larger and larger proportion of total supply, its characteristics have become much more influential. Much of the oil industry, to some degree, has had to abandon long-term projects and favor short-cycle projects as well.
On top of that, Saudi Arabia is much more concerned about losing market share than it was, say, a decade ago. That means it has an incentive to keep prices from rising too much. But Riyadh also needs prices from falling too low due to budgetary pressure. So, Saudi Arabia wants prices within a relatively narrow range, evidenced by the two OPEC+ deals it helped engineer.
In other words, much of the oil market itself is more elastic, responding to market forces in order to push prices back within a tolerable range.
Demand, too, is more elastic. Emerging markets have trimmed fossil fuel subsidies since the market crash in 2014, which exposes them to the swings in prices. In the past, hefty subsidies would keep consumption humming along even if global prices spiked. Now, emerging markets see demand accelerate or fall back in response to prices. This helps smooth out volatility.
Finally, Barclays argues that the negative correlation between the U.S. dollar and oil prices has broken down. That also means that emerging markets will feel volatility more. If the dollar strengthens and oil prices no longer fall in response, then the price effect in emerging market currencies is more pronounced. As such, demand dips, which ultimately reduces the harshness of price swings as well.
Major investment banks may be sanguine about volatility, but there is no guarantee that their predictions are spot on. If anything is true about the oil market, it is that the one constant is volatility. Wars, recessions and technological change have a long track record of upended even the most carefully crafted forecast.
By Nick Cunningham of Oilprice.com
