Robin Mills, in his column of August 4, takes exception to the thesis, proposed by the University of California at San Diego economist James Hamilton and me, that oil prices are likely to stay high. This is part of a larger debate, not only about the prospects for oil supply growth and oil prices, but for strategic options for countries such as the UAE and major oil companies such as Exxon and Chevron.
The oil price debate can be boiled down to three schools of thought.
Two of the three analytical approaches are demand-driven and can be respectively associated with Citi Commodities Research, on the one hand, and BP and the OECD’s International Energy Agency (IEA), on the other.
Citi takes the view that oil demand is thin, that there is potential upside in the liquids supply, and that fuel substitution will soon begin to siphon demand from oil-based fuels. Thus, oil prices are likely to collapse, with Ed Morse, the head of commodities research at Citi, typically forecasting oil prices in the US$65 to $90 a barrel range, Brent basis.
These numbers have not been realised to date. Nevertheless, if one took this view, then investing in upstream capacity hardly makes sense. Thus, the UAE or the oil majors should take an essentially defensive position in the market.
BP and the IEA have another version of this argument, in which supply outpaces demand, but high prices remain. BP, in its Energy Outlook 2035 (January 2014), elaborates on this perspective, stating: “The market requirement for Opec crude is not expected to reach today’s levels for another decade before rebounding. While we believe that Opec members will be able to maintain discipline despite high levels of spare capacity, cohesion of the group is a key oil market uncertainty.”
BP, like Citi, sees demand as thin and vulnerable to increased supply. Prices do not collapse, however, due to Opec's long-term willingness to hold high levels of spare capacity.
Thus, if the UAE accepted the BP point of view, prices remain high, but alas UAE production volumes will fall. Again, this is a bearish signal and would lead the UAE to take an essentially defensive position with respect to upstream investments.
What is the reality? Is the UAE’s strategy aligned with BP or Citi’s analysis? Not to appearances. UAE oil and liquids production are both at record highs. Oil production has increased modestly, but total liquids production is up 21 per cent in the last decade, and up 4.6 per cent in just the last two years.
Will this trend be reversed? Does the UAE plan to be more defensive in the future? In fact, no. Production capacity in the Emirates is slated to increase by 23 per cent to 3.5 million barrels per day (bpd) by 2017. Thus, UAE production and capacity plans suggest that decision-makers there assume prices and volumes demanded will continue to be robust. This implies that either UAE decision-makers do not believe Citi and BP, or they are making bad decisions.
On the other hand, using a supply-constrained approach UAE strategy makes sense. This school of thought argues that supply continues to lag demand, leading oil prices to rise to the full level that the global economy will bear (the “carrying capacity” price). From this point, prices will be difficult to increase. But exploration and production costs will continue to rise, and this will limit supply, particularly from the oil majors and conventional sources.
In this interpretation, there is plenty of demand, but the potential for only modest oil price appreciation. The oil system in this view is price-stable and volume-insensitive, and the UAE is correctly responding to market pressures by raising capacity and production. Indeed, it may have latitude to increase production above current targets.
The supply-constrained model is seeing a test right now. Shale oil growth in the US is simply astounding, with US supply up 1.5 million bpd in the last year. Add Canada, and North American production is up a phenomenal 1.8 million bpd last month compared to a year ago, even as the Libyans have re-entered the market in a modest way.
According to industry sources, the rest of Opec has yet to respond with production adjustments. Meanwhile, European and Japanese economic data continue to disappoint. Brent has been weak, but is holding above $100 a barrel, even in the face of a supply onslaught and feeble demand from advanced countries.
If the supply-constrained theory is right, Brent oil prices should tend to hold near recent levels. A bigger supply surge might depress oil prices for a time, but latent demand should quickly soak up any excess supply, returning prices to the level of the past three years. If that’s the case, the UAE will have made the right call to increase its production capacity. The world remains short on oil, and the UAE is stepping up to provide it.
Steven Kopits is the managing director of Princeton Energy Advisors and can be reached at firstname.lastname@example.org. He is writing a book on supply-constrained oil markets analysis.
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