At the time of writing a barrel of Bent crude oil is close to $71, down from around $109 at the beginning of 2014 and up from about $32 from the beginning of 2016. Prices of petrol are fairly obviously largely derivative of oil prices and, as French President Emmanuel Macron has experienced first-hand, petrol prices are very important to rural residents and can easily become a salient political issue. In this week’s blog post which is supposed to serve as a sort of introductory guide to understanding oil markets I want to explain some of the most important factors when it comes to oil prices, describe some of the trends in the oil industry, and speculate about how the oil price will move in the future. I have written on oil in the past and speculated about oil prices with mixed success, but as the old saying goes: ‘predictions are difficult, especially regarding the future’.
Before we get into the factors and trends which determine oil prices I will briefly explain some terminology.
Brent
A type of oil found in the North Sea used as a benchmark for oil prices
Barrel
The standard unit for measuring amounts of oil, one barrel is 159 litres
Hydrocarbons
An umbrella term for natural gas and oil as their chemical make
up consists of long chains of carbon and hydrogen
Shale
A type of rock from which shale oil and natural gas can be extracted
Shale Oil
A form of unconventional oil which is a substitute for regular crude oil
Tight Oil
Crude oil found in difficult to reach rock formations which require the same extraction methods as shale oil
Fracking
Hydraulic fracturing, commonly known as fracking, is a process of pumping a special fracking liquid at high pressure into rocks which hold hydrocarbons to be able to extract those hydrocarbons
OPEC
The Organisation of the Oil Exporting Countries, an intergovernmental institution established in 1960 to coordinate member states’ oil production to keep prices at acceptable levels
With these terms established let’s explore how oil markets work, how oil prices are set, and how the industry is changing. Oil is as you probably know extracted in places across the world but for this introductory guide we’ll focus on two places: the Middle East and the United States of America. There are many more places where significant oil reserves are held and where significant amounts of oil are pumped like Russia, the North Sea, Venezuela and North Africa but this blog post has a limited scope so therefore the focus will be on the USA and the Middle East. The Middle East is important both because of the large amount of oil the region produces and because of the prevalence of ‘petrostates’ in the region. A petrostate is a state which bases its social and economic model on its oil exports, a good example is Saudi Arabia where the monarchy is able to essentially bribe its population with free electricity and subsidised fuel prices to legitimise the regime. The US is important due to its ‘shale revolution’ which started around the start of this decade where technological advancements in the form of fracking and horizontal drilling made it profitable to extract shale oil and tight oil which sparked frantic oil rushes just like it had when the oil industry took off the first time in the 1860’s. The US and the Middle East are interesting cases to compare as the Middle East generally produces oil in a traditional way whereas the modern American oil industry is founded on shale oil and tight oil. This means that the production costs for the US are far greater than the production costs in the Middle East.
Given that production costs are significantly greater in the US as compared to the Middle East paired with the speed at which the US’ oil production increases, some believe that the US will be a net exporter of oil by 2022, one might believe that the rise of American oil puts upwards pressure on oil prices. This is not necessarily the case though, while the cost of producing oil is lower in the Middle East than in America the primary actors are different. In the US it is private firms which are in the oil business and their only objective is to turn a profit, but in the Middle East most large oil firms are state owned and the state needs to sell at a much higher price than the private firm does to not enter a fiscal deficit. The petrostate model is expensive to maintain and requires a certain oil price for the state’s budget to make sense, if prices are lower than their fiscal breakeven level then the state will have to use its reserves to pay for its obligations which is obviously not a sustainable state of affairs. In reality the American ‘Shale Revolution’ is putting a downwards pressure on oil prices as, according to the estimates I’ve seen, the fiscal breakeven price for Saudi Arabia is ~$90 whereas the breakeven price for American shale oil producers are ~$40.
Of course, these two required prices levels wouldn’t be conflicting if the oil market weren’t a globally integrated market where all actors are price takers. What does that mean in plain English? The reason why oil prices are close to the same in the US and Saudi Arabia despite different breakeven prices is that oil is easy to transport and because no single producer is big enough to be able to singlehandedly change prices.
As for the question of fracking and if one should expect the practise to become more common I’d say it’s hard to tell. There have been some trials in the UK but in both the UK and the US there are many who oppose fracking on the basis that it is harmful to the environment. I doubt that states which are already engaged in fracking on a large scale would prohibit the practise, but I think it could be difficult for fracking to get started, especially in rich democracies where the environment is an important political issue. Fracking is probably here to stay in the places where it got started but don’t expect it to start up in many places, it does require advanced extraction techniques, a fair amount of know-how coupled and at least in the beginning a quite high oil price to justify the investment in the tools needed to start.
What then are the things to watch out for and what do I believe will happen to oil prices moving forward? What to me seems to be the most important factors for predicting how oil markets will look in the future are the following:
OPEC+
Recently OPEC have started making agreements with Russia, a constellation sometimes referred to as OPEC+ which, if it can agree and overcome the incentives to cheat on their arrangements, will have a large impact on oil markets given the sheer scale of their combined oil exports. If OPEC+ announces a new export target you best take them seriously, oil futures markets certainly will.
Middle East Regional Stability
The Middle East has enormous oil reserves and in many cases precarious political situations. It wasn’t long ago that there were large scale protests in Iran over food prices and there’s still fighting in both Yemen and Syria. If something happens in the Middle East which creates political instability it will almost certainly impact oil production and oil prices.
American Unconventional Oil Output
American production of shale oil and tight oil has increased at an incredible rate and as mentioned previously America will likely be a net exporter of hydrocarbons in less than ten years. Keeping up with how fast the American shale and tight oil output increases is important to understanding oil markets as unexpected changes in American unconventional oil output will most likely have a direct impact on oil futures. I’d personally keep an extra close eye on the Permian Basin, a region in Western Texas which is the region of the US which produces the most hydrocarbons.
Eastern Demand
It used to be that most oil was consumed in the West as most of the highly developed economies were there but as the West has grown richer and as the issue of climate change has become more politically important the West’s demand for oil has stopped increasing. Simultaneously China has grown at a breakneck pace and much of its industry runs on oil. India is also growing and as the two most populous states in the world both grow richer their populations start wanting to consume more energy and in the near future almost all the increase in demand for oil will come from the East.
Where will oil prices head in the future?
I personally think that we’re headed for higher oil prices as the price at the moment seems to low for sustaining the petrostate model. It could be that some petrostates start facing legitimacy problems when it gets difficult to keep the economy or government spending going at $70 per barrel which leads to political instability making it more difficult to extract and export oil. As far as I can tell, the most likely cause of a decrease in the price of oil if that was to occur would be a recession in China and/or the USA as those are major oil consumers and a recession means a decrease in demand for oil.
I hope you enjoyed the Ipoleco beginner’s guide to understanding oil markets, if you found it useful please share it with a friend or co-worker. If you want to read more on the subject I’d recommend The Prize: The Epic Quest for Oil, Money, and Power by Daniel Yergin for a historical overview of oil, Nick Butler’s weekly column on energy in the Financial Times, and finally I want to give a shoutout to Andreas Goldthau as it was his course on global energy policy which both inspired me to write this piece and which taught me more or less everything I know on the subject. If you would be interested in a follow-up intermediate guide to oil or energy more broadly please let me know via Twitter, and thank you for reading!
Written by Karl Johansson, Founder of Ipoleco
