If you are interested in crude oil as an investor, an analyst or a consumer there is no shortage of conflicting opinions out there. For industry outsiders it is even worse – crude oil price outlook is a puzzle with multiple pieces that are impossible to put together.
We are going to run out of oil! No we are not. Alternate energy is going to completely replace fossil fuels when it comes to power generation in coming year! Not going to happen in the next forty years. Electric and hybrid vehicles are going to kill the petrochemical industry by reducing demand for petrol and diesel down to zero! Wrong again. The contradiction and conflicts are endless. Lets see if we can find answers to some of these questions and chart a path of clarity through them.
There are three primary schools of thoughts when it comes to predicting the future price of crude oil.
Which one of these views is right? What are these structural reasons markets refer to? What is the likely future of crude oil and how will that impact the global economy?
The two primary schools of thoughts originate from two different groups of stake holders. The oil prices are likely to go high school is directly or indirectly linked to groups that benefit from higher oil prices. Oil producing nations and large production, exploration and distribution companies would like to see prices drift higher and their default thinking and opinions reflect that. The natural optimism of business that whatever we are doing is rational and in the collective best interest of the industry.
Similarly the low price school of thought is driven by industry shorts and technologists. Same rationale as the first group – default group think. The reality is somewhere in between.
One way of drilling down to the actual signal embedded in all the analysis floating around the world is to look at two of the largest markets on the demand side. US and China. If we can build a better model of supply in demand in these two markets the remaining pieces of the puzzle will fall in place.
Fortunately for us EIA – the US government agency (Energy Information Administration) produces a great deal of data and public analysis on supply, consumption and inventory trends within energy markets. In this series of posts we want to look closely at some of the EIA work and see if we can use it as a foundation to build our own models.
To a student of oil opinions don’t matter. Methodologies do. EIA produces an Annual Energy Outlook (AEO) report every year that updates their base case for long and short term oil price forecasts. The most recent report was published on 5th January 2017 and remains unaffected by biases introduced by the transition of power in the US from the Democratic to the Republican party.
While the report is limited to US energy trends, the approach used is quite instructive and can be applied to global trends or other specific regional markets such as China, India and Western Europe. Even without extending the approach to other markets, remember that US is the largest global consumer of energy products as well as the one with the deepest financial markets where these products trade. In 2008 it was the pressure wave created by the same financial markets that first took prices to $147 a barrel and then brought them down to US$ 33 a barrel.
Our interest is in the following specific questions given the coverage we have been seeing in recent years on the impact of technology on crude oil.
A better understanding of US needs can help shape our opinion with respect to what the future holds for oil prices. The EIA AEO report breaks down oil price forecast by breaking down oil consumption by sectors. It further analyzes this data by reviewing consumption and growth under a collection of scenarios. The first one is what is called the reference case. A most likely base case created by extending the current trends in technology, resources, demand and growth. The reference case is supplemented by 6 other cases.
The 2017 EIA AEO report does not bode well for future oil demand. Under the 7 scenarios including the reference case there are only two scenarios where US does not end up as a net exporter of energy products. The transition happens as early as 2020. So even if the supply glut that has been casting a dark shadow on prices since 2014 clears up, a much bigger glut is likely to hit the market within the next 24 months as supply and demand curves within the US market shift. An initial read of the report suggests a mostly negative outlook when it comes to the future of oil prices.
A number of factors have been driving this outlook. To better understand where oil is going we have to understand how crude oil is used and what consumption looks like. Oil consumption is broken down into four primary uses.
We review the AEO report in the series of posts that follow and take a deeper look at:
Hang in to your seat belts it is going to be an interesting ride.
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