Why oil could plunge to $20 a barrel, but probably not $10
Many producers still pumping at under $30 a barrel
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Oil futures dived back below $30 a barrel on Friday, but even that might not yet be enough to sufficiently choke off production and allow crude to put in a bottom, one economist calculated Friday.
That’s because a key question for oil traders is whether producers should emphasize current prices or those further in the future, wrote Julian Jessop, head of commodities research at Capital Economics, in a note.
After all, producers don’t just look a the spot price or the nearby futuresCLG6, -4.81% but are instead focusing on long-term contracts, including producer hedges, he noted. As a result, decisions on whether to invest in further production are dictated more by expectations for prices over the lifetime of a project rather than where they are right now.
Longer-dated Brent futures, he notes, show prices projected to rebound to around $50 a barrel by the end of the decade. Then there are production costs, which vary by producer, but also depend on whether the focus is on short-run operating costs or include long-run capital expenditures.
“In principle, firms will continue pumping oil as long as the selling price is above the short-run (or cash) cost. However, new investment will evaporate if prices are expected to be less than the long-run (break-even) cost,” Jessop wrote.
He points to the chart below, which offers a rough estimate of production costs. At around $30 a barrel, the current price of oil is still well above short-run production costs for major Middle East countries and the U.S., Jessop said.
And that is one major reason why it makes sense to brace for a further fall in price, he said. Capital Economics sees scope for oil to fall as low as $20 a barrel, but thinks calls for crude to drop below $10 goes too far. Although such a price would still be above Saudi Arabia’s production costs, “it would be impossible for Saudi Arabia to supply the whole world (even if it were willing to do so at such low prices given the country’s fiscal constraints),” Jessop said.
Capital Economics is forecasting oil to end 2016 at $45 a barrel, rising to $60 in 2017. A steeper near-term fall in oil prices is likely to lead to bigger supply cuts, which would allow for a stronger rebound in prices when it finally does arrive.
In other words, “if prices did keep falling in coming weeks, we might actually become more confident” in those price forecasts, Jessop said.
