Based in Brisbane, Geoffrey Cann is Deloitte’s National Director, Oil and Gas.

Based in Brisbane, Geoffrey Cann is Deloitte’s National Director, Oil and Gas.

By Geoffrey Cann

WHEN it comes to where the price of oil is going, there are a lot of questions (and potential answers) to consider.

Will it bounce back quickly – or sometime in the distant future? How high will it go? What will happen to LNG prices? Will they bounce back? And what factors weigh most heavily on determining the shape of any price recovery?

The heady days of US$110 oil certainly look to be many years out, with the oil futures forward curve pointing to a gently rise in prices for many months, and not back to US$90 (as in September 2014) until 2018.

Oil traders are therefore betting that demand (from Europe, the US and Asia), and supply (OPEC cutbacks, cancelled Canadian oil sands expansions, US shale shut-ins), will only gradually balance, leading to at best a prolonged, incomplete and gradual recovery.

But are they right? There are a few other factors to consider when it comes to potential to inf luence a sudden, sharp and accelerated upward price shift:
• An OPEC change of heart – could OPEC change its policy towards natural market balancing at its upcoming June 2015 meeting?
• A Russian play for growth – Russia’s economy is highly dependent on a high oil price, it’s government is particularly skilled in the fine art of using oil and gas for political means, and it’s unpredictable
• A policy shift in Beijing and/or Washington –watch the likes of China’s air quality this winter, the Keystone XL decision, the pace of approvals for more US oil exports, and the upcoming US election to detect potential shifts in climate agenda as an oil price inf luencer
• A natural disaster – tsunamis, earthquakes and hurricanes can drive price shifts (although hoping for one is clearly not good strategy)
• Demand resurgence – cheap oil stimulates greater consumption which will lift the price
• Supply failure – finding fresh supplies to replace what’s been produced is no easy task anymore. Supply will eventually fall short against a relatively inelastic short term demand.

For now, the pressures exerting downward force on prices show no signs of letting up.

Technology advancement is increasing the energy efficiency of consuming devices, and making every drop of fossil fuel stretch further (although history teaches us that we rarely bank these savings).

Research into fracking and drilling technologies, well monitoring and reservoir simulation will continue to help expand shale basins, and battery technology improvements, solar efficiency gains, and improved wind turbines will lead to increased substitutes for fossil fuels.

During the GFC, economists came up with clever ways to describe how a recovery might unfold, including the L-U-V model (and hence the alphabet soup reference).

I’ve applied the same model to oil prices, but think we also need a fourth curve – what I call a reverse J (or the fishhook).

The V

In this scenario, oil prices rise quickly back to where they were (favoured by OPEC and other producers that are oil export revenue reliant).

The forward price curve suggests a V shape, albeit an oddly shaped one – its right arm rising at a very shallow rate, pointing to future prices below the peak.

The U

Oil prices settle in on some floor (optimistically in the US$45-US$50 range), bumping along for a period before rising quickly back to US$110.

However US shale producers continue to show short term production growth, and traders are hoarding millions of barrels for eventual release.

To get a spike in prices, we’d need to see a serious drop in production, the elimination of stored inventory, a big spike in demand, or some combination of all three (and none of which are plainly visible at the moment).

The L

There is a real risk of this scenario – where prices fall to a new level and never return. Carbon policies in the US and China, research on the need to strand fossil fuels, the rise of renewables, improvements in battery technology to store power and eliminate fossil fuel from transportation, the substitution of gas for coal, all suggest that fossil fuel is becoming the stone of the stone age.

If these substitutes pick up pace and market share to displace fossil fuels permanently, then L is our future.

The reverse J (the fish hook)

Prices eventually rise but not to pre-fall levels.

Cutbacks in producer capital spending, project cancellations, and workforce reductions plant the seeds for an eventual reduction in supply that balances with demand. Ideally OPEC picks up any spare share made available by shale’s retreat.

To make the strategy work, OPEC countries need to be ready to ramp up production once demand overshoots supply.

The worry is that in a low oil market, even they lack capital to expand their production, a problem since shale is going to be cheaper in the future as costs come out, and because it can come to market via lots of small wells, rather than the megaprojects typical of OPEC.

This suggests the price will settle at the marginal cost of future shale production – between US$50 and US$70/bbl.