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A Year After Oil Prices Fell, Supply and Demand Take Charge

Now that Saudi Arabia has walked away from its role as the world’s swing oil producer, U.S. output will determine prices.

July marked the one-year anniversary of the sudden plunge in oil prices, from roughly $105 to $45 per barrel. This has been no ordinary price decline. The drop precipitated a change in a long-term feature of the global crude market. Saudi Arabia decided last year to chase market share rather than serve in its traditional role as the regulator of oil prices through the Organization of the Petroleum Exporting Countries (OPEC).

As a result, the output of U.S., rather than Saudi, producers will likely determine oil prices in the near future. The question now appears to be, How far and how fast — if at all — prices will rise?

Today’s crude oil narrative begins with American shale deposits, which have allowed the U.S. to leapfrog Russia and Saudi Arabia in oil production. In a June research note, Edward Morse, global head of commodity research at Citigroup in New York, called this “the most politically disruptive situation in oil markets in decades.” In reaction to this change, Saudi Arabia, after decades of willingness to export less to control prices, decided instead to sell as much as it could. That decision, added to the supply glut U.S. production helped create, triggered last year’s bear market in oil prices. At times this year, production in Saudi Arabia has surpassed 10 million barrels per day, touching record levels. Other OPEC members have followed, according to data from the International Energy Agency (IEA).

Without a high-output market willing to step in and act as the swing producer, as Saudi Arabia once did, market forces are now in control. When prices fall, producers with higher costs are likely to shut down operations, balancing supply and demand rather than relying on the Saudis to do so. That process is under way now. Drilling in the U.S. has declined in reaction to falling oil prices, with the number of active rigs dropping for 29 consecutive weeks and counting, according to Baker Hughes, the oil field services provider whose weekly drilling updates are the industry’s accepted indicator.

Prognosticators like Morse are no longer entertaining thoughts of $20-per-barrel prices, which was considered possible in February, when crude oil was trading below $50 per barrel. With Brent, West Texas Intermediate and other crude oil benchmarks hovering around $60 for the past couple of months, market watchers are trying now to determine whether supply has already fallen enough to balance demand, or if more needs to go. Francisco Blanch, head of global commodities and derivatives research for Bank of America Merrill Lynch Global Research in New York, believes that crude prices are likely to slip in the next few months. “There’s a lot of players living on the edge, running out of cash flow and holding on in the hope that a price recovery will bail them out,” he says. “We need to see some of these players disappear or merge.”

One factor likely to help that consolidation is the expectation that the Federal Reserve will raise interest rates this year, boosting financing costs for U.S. producers, he says. Blanch believes that, after a brief drop to knock out the highest-cost producers, crude will rise over the next two years, but to no higher than $70 a barrel. Morse, in his June research note, suggested that prices would need to remain below $75 to discourage high-cost producers.

Another possible catalyst for a short-term price drop would be the return of Iranian oil exports to formal markets. If negotiations under way to restrain the country’s nuclear program bear fruit, winding down sanctions against the country in the process, Iran is likely to quickly sell anywhere from 30 million to 50 million barrels from inventory the country has stored in oil tankers at sea. That could mean a short period of excess supply and low prices. Over the long term, an Iranian return would clear the way for foreign oil companies to invest in the country. Iran has the potential to add 600,000 barrels per day to the global market in the first year after the lifting of sanctions, says Blanch. Large additions beyond that would require investment in new projects.

Other geopolitical wild cards include Iraq and Libya, which are producing below potential and could add even more competition for market share if security and political stability improve.

On the demand side of the price equation, the crude oil price drop in the past 12 months has revived consumers’ appetites. Demand for crude products touched a five-year low in the second quarter of 2014 but has rebounded, according to the IEA’s June Oil Market Report. In the first half of 2015, daily deliveries averaged 93.3 million barrels per day, up 1.6 million from the same period a year earlier. U.S. consumers are driving more, according to the U.S. Department of Transportation’s Federal Highway Administration, with the total miles traveled up 3.9 percent in the first quarter of 2015. According to Blanch, demand is also coming from China, where vehicle sales are rising.

Overall, the uptick in oil consumption refutes the belief, popular until the slump last year, that demand for crude had peaked. That expectation was based on fuel-efficiency gains for cars, fears over climate change discouraging use and falling costs for renewable energy technologies. The past year shows that consumers are still willing to use more oil when it’s cheap, and that suggests that excess supply in the market could be snapped up and trigger higher costs and a reawakening of drilling activity, says Jeff Bellman, North American energy analyst at TIAA-CREF Asset Management in New York. He expects oil prices to approach $90 a barrel by the end of 2016: “The oil market looks a lot better than what I see as the consensus. The seeds are being sown for a better price recovery.”

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