Black Gold and Black Swans

Market fundamentals point to a continued slide in oil prices. But the deck is stacked with jokers, and they're mostly wild.


Everybody is trying to get a handle on where oil prices will be next year after a whiplash-inducing slide of nearly 50 percent since summertime highs.

Everybody is trying to get a handle on where oil prices will be next year after a whiplash-inducing slide of nearly 50 percent since summertime highs.

The price of oil matters for regular folks at the pump and for oil companies trying to make multi-billion dollar investments. It matters for petro states that rely on crude sales to fund their budgets, pacify their people, and pay for foreign policy adventures. It matters for policy makers, too: Central bankers have to adjust fiscal stimulus plans to make sure they don’t pile on to the economic boost that results from people gifted with surprise cash from cheap oil; U.S. politicians need to decide whether to export oil or not. And all the chessboard moves of international geopolitics will play out differently depending on whether oil is sell-the-dog-expensive or get-a-Hummer-cheap.

Obviously, the tricky part is figuring out which it will be. The fundamental mismatch between supply and demand that drove the recent plunge is still in place, even though oil prices zigged upward Friday to $56 in New York and $62 in London.

The world still pumps more oil than it needs: OPEC hasn’t really curtailed production, and the American gusher has shown no sign of slowing down, even as countries like China that for years drove reliable growth in oil demand are suddenly downloading bootleg recordings of Al Gore lectures.

Today’s mainstream forecasts suggest that mismatch isn’t going to disappear next year, which means prices could just keep falling from their current near five-year lows around $60 a barrel. Heavy hitters inside OPEC this week raised the prospect of oil hitting $40 a barrel next year.

The International Energy Agency expects non-OPEC producers — that is, countries like the United States, Russia, and Mexico — to increase output by 1.3 million barrels a day, while global demand is expected to rise only 900,000 barrels a day. OPEC throws up different numbers, but paints a similar picture: Non-OPEC growth of 1.7 million barrels far outstripping the extra 1.1 million barrels the world would need.

So oil market bears should be sharpening their claws, then. Except they might get gored by bulls charging in the opposite direction. That’s because there are a bevy of big and as yet unanswered questions that could fundamentally alter the shape of oil markets next year, and even push prices much higher. They include questions about supply, demand, market psychology, and good old geopolitics.

Start with supply. OPEC famously stood pat at its last meeting in late November and opted to maintain current production levels and take falling prices on the chin rather than cut back production to send prices back up. Key OPEC officials insisted then that the market would correct itself; Saudi Oil Minister Ali al-Naimi reiterated this week that he sees weak prices as a “temporary” phenomenon.

But that’s easy for the Saudis to say, sitting as they do on more than $700 billion in cash reserves. Other OPEC producers, such as Iran, Iraq, and Venezuela, desperately need higher prices to plug gaping holes in their budgets.

So one big question is: Will a continued slide in prices force OPEC to blink and call an extraordinary meeting before June to try to cut back production and wrest back some measure of control? Given Saudi Arabia’s passive approach so far, many oil experts doubt OPEC will lift a finger before the summer, if then: “the odds are currently quite long which will help keep prices low through” the first half of next year, London-based Energy Aspects said in a recent research note.

The other big supply-side question is in the United States. Lower oil prices make life tough for frackers, because it costs more to blast open underground rocks than it does to tap into easily accessible reservoirs in the deserts of Arabia. But nobody knows how low oil has to go before the economics don’t work — in large part because frackers have gotten so much more efficient in the last three years.

Most experts figure that U.S. shale is safe with oil above $70 a barrel. In the $60s, quite a few projects start to look iffy. In the $50s, it’s an open question whether Wall Street will even keep financing new wells, regardless of whether producers want to keep drilling or not.

So the question for U.S. oil output becomes: At what point do lower prices crimp U.S. output, and how long might that take? The longer U.S. producers hold out and keep increasing production, the lower prices could potentially fall. But if marginal projects get knocked out early and slash U.S. output, that could prop up prices enough to bolster the rest of the industry.

Then there’s the demand side of the picture. Granted, right now the global economic prospects are gloomy. For months, the IEA has been progressively slashing its demand forecast from the month before; the latest estimate included a further reduction in expected demand growth of 230,000 barrels of oil a day next year.

But there are plenty of wildcards. As a rule of thumb, lower oil prices stimulate demand, the same way that rising prices crimp it. Except when they don’t. Falling demand this year led to lower oil prices, but those lower prices didn’t spur any extra demand growth. In June, the IEA expected global demand this year to increase by 1.3 million barrels a day. By November, despite the freefall in prices, it was clear that no such growth had materialized, with the annual increase in oil demand only half that.

Perhaps demand will rebound yet: U.S. car sales in November were brisker than anytime since 2001, with big, gas-guzzling sport-utility vehicles especially popular. Or perhaps it won’t: Chinese auto sales have slumped to the lowest level in two years.

There’s also a new dynamic that is becoming increasingly important: Oil demand in oil producing countries themselves. For decades past, the United States apart, oil producers pumped, and rich countries consumed. Now, though, some of the biggest sources of demand growth are in oil-producing regions, especially the Middle East but also–until recently–in Russia.

Plunging prices are hammering those economies–witness the Russian rouble’s spasms of agony in recent days–which in turn lowers their own demand for oil. The main driver behind the most recent IEA revisions was actually a gloomier outlook for Russian domestic oil demand in the wake of the price collapse. That’s a vicious circle in the making, because lower oil prices hurt those economies, which kills demand and budgets, which requires even more oil sales, which further lowers prices.

But there is one potential sleeper source of demand growth that has nothing to do with car sales or economic growth. China is still trying to build up strategic petroleum reserves of the kind that the United States and Europe filled up after the 1973 OPEC oil embargo. Right now, China’s strategic reserves are only partly filled, and the country is nowhere near its target of having 90 days worth of imports on hand. Historically, since announcing the program in 2000, both the Chinese government and Chinese firms have taken advantage of lower prices to stock up on cheap oil; traders attributed price spikes in early 2012, for example, to Chinese stock builds.

But the lack of transparency in Chinese reserve practices make it hard to know exactly how much oil the country will buy, or when. Some ballpark estimates suggest the country could import an additional 130,000 barrels a day to 230,000 barrels a day next year to fill underground caverns, which would provide upside support for oil prices.

Those questions of physical supply and demand are all part of the what’s-happening-now side of the oil market; the other part is what will happen in the future, and affects where traders see oil prices heading. Put briefly, if falling oil prices today panic oil producers into throttling back future production plans, then the future supply-demand balance looks a whole lot tighter, which could send prices back up.

For instance, oil experts Wood Mackenzie said Thursday that lower prices could force big oil companies to drastically slash their capital investments next year. Likewise, Brazilian expectations of a spurt of production from its deepwater oil fields are wilting with prices around $60. Chevron has shelved plans to drill in the Canadian Arctic “indefinitely” thanks to lower prices. Oil sands development in Canada is also threatened by lower prices.

And Iraq, whose hugely ambitious oil-development plans are meant to provide the bulk of the world’s future oil, is throttling back those expectations in light of falling prices and rising terrorists. “It may be necessary to revisit our ambitious plans for the next five years,” Iraq’s deputy prime minister said this week.

In all, investment bank Goldman Sachs said in a research note this week, about $1 trillion worth of future oil projects are now at risk thanks to lower prices. If traders decide that the prospect of losing more than seven million barrels of future production is enough to start worrying, then prices will rebound.

Finally, there’s a whole quiver of geopolitical wild cards that could affect physical oil production, simply spook markets, or both; either could send prices up sharply.

The Islamic State, the terrorist group that holds big swathes of Iraq and Syria, could finally move south and threaten the heart of Iraq’s oil industry. A sanctions-battered Russia could further escalate tensions with the West, rather than backing down in Ukraine. Venezuela’s tottering economy could drive off the cliff, threatening millions of barrels of oil output and broader chaos. Libya’s militia-fired nightmare continues, and that has already whacked hundreds of thousands of barrels a day of oil output. South Sudan’s oil industry is in such a bad way that hiring ex-Blackwater guards for oilfield security is an improvement. North Korean muscle-flexing might move beyond just box-office bombs. China will again be drilling in the South China Sea next year, likely in waters claimed by other countries that are increasingly snapping up warships to push back. Turkey and Cyprus could come to blows over access to offshore natural gas fields. And so forth.

In other words, while relatively low oil prices today and seemingly bearish oil-market fundamentals may point to more of the same next year, the humbling reality is that no one really knows — and yet no one will be shielded from the consequences.


Keith Johnson is a deputy news editor at Foreign Policy. Twitter: @KFJ_FP

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