Will oil prices fall below zero? Fear more than fundamentals is driving markets lower

Matthew Tillett
The supply glut is not as bad as many analysts think (Source: Getty)

Reporting by Clive Crude...

How low can it go? This is the question every oil analyst is asking. First they thought $100 was the floor, then $70, then it was $50, then $25 and even $10 has been mooted. Yesterday, we read that “petrol is to be cheaper than water”. Today, leading energy expert Oli Bear has forecast that the price of a barrel of Brent Crude could actually fall below zero. You thought it wasn’t possible, but perhaps it is.

After an 18 month-long collapse in oil prices, analysts appear to have given up any hope of underlying fundamentals determining oil prices. As Bear himself put it: “Oil is a financial asset. Traders and speculators determine the price and it is clear that the direction is down. Fundamentals are not relevant anymore”.

When asked how far the price of oil could fall below zero, Bear responded: “Is it really that incredible to suggest that the price of oil could turn negative? After all, investors have bought German government bonds with negative yields. Why should oil have any value?”

As the oil price sinks to new depths, and analysts fall over themselves to see who can come up with the lowest forecast, it is worth asking what, if anything, has changed. My answer is: very little actually.

The oil market remains modestly oversupplied to the tune of less than 1 per cent. With the collapse in the price and all the slightly hysterical commentary that has come with it, one could be forgiven for thinking that the supply glut might be worse than this. But it isn’t. The fundamentals point to a far less oversupplied market than in previous oil price down-cycles.

In fact, 2015 was a record year for production as everyone sought to maximise cash flow into a falling market. Looking forward, outside Iran, there is little spare capacity left – a very different situation to previous down-cycles where Opec had huge surplus capacity.

Capital expenditure was slashed in 2015 and we will likely see similar falls again this year. Exploration spend has all but disappeared entirely. This reflects the fact that the marginal cost of new supply is way above the current price, making it uneconomic for oil companies to invest in future production. With existing oil fields declining at 3 to 5 per cent each year, and US shale decline rates even faster, supply is therefore highly unlikely to grow at the pace it did last year and it may even fall due to natural decline.

Costs are now falling across the board as the industry tries to reset itself for a world of lower oil prices. But the full benefit of this deflation will only come through in future years. Investors have written off Opec even though most member countries are running enormous budget deficits at current oil prices, suggesting some sort of cooperation in future is likely.

Despite all the bearishness, 2015 was a record year for oil demand, just as it was for production. And industry forecasts are for demand to increase again this year. Fear more than figures is driving the oil price and oil company valuations in a downward spiral, as analysts and investors lose faith and sight of the long-term fundamentals.

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