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The Long Term Average Price Of Oil Is $30 A Barrel

Business, China, Company Strategy, Economics
By John Richardson on 06-Mar-2015


By John Richardson

OIL and petrochemicals markets have behaved from mid-February until today as if the world is about to return to the way it was in the first half of last year.

Here is the thinking behind this behaviour:

  • What happened from around September 2014 onwards in crude market until mid-February of this year was only a temporary “supply side” problem – and not a demand problem. The supply problem was that the world had underestimated the rise of shale-oil production. Most people had also thought that Libyan output would be lower than it has been. Most importantly of all, the vast majority of analysts did not anticipate that OPEC, led by Saudi Arabia, would prefer to defend market share rather than the oil price.
  • “Temporary” ended up being a lot longer than most had expected, granted, but the assumption held that supply of oil would eventually start to match the new price. Cuts in production would have to result in a price recovery – if not to $100, at least to levels much-higher than we saw in January.

And sure enough, February saw a rally in oil prices and, in the case of Brent, greater stability around $60 a barrel.

So we have seen restocking by many petrochemicals buyers as they respond to both the rise in crude and its new-found stability. No purchasing manager for a plastics converter or a big consumer-goods manufacturer wants to be accused of failing to buy raw materials today, when the consensus view says that they might well be more expensive tomorrow.

This is the biggest factor behind the rise in Asian petrochemicals pricing since mid-February. Supply factors in some of the petrochemicals markets themselves are also having an influence – for example, most notably at the moment in polyolefins, which I will look at in detail in Monday.

But what this rally really comes down to is end-users changing their approach from the “hand-to-mouth” buying, which was the dominant approach in September 2014 until mid-February of this year, to “buying ahead of further oil-driven petrochemicals price rises”.

There is nothing wrong with this strategy, of course. Traders, producers and buyers of petrochemicals have been absolutely right to follow this short term trend.

Most traders, producers and buyers of petrochemicals will also be right if they demonstrate extreme caution as we get closer to Q2. The reason is that the second quarter could well see another sharp retreat in oil prices. Some analysts think that longer oil supply could drive prices down to $30 a barrel, perhaps even $20 a barrel.

But in H2 of this year, one assumption is that oil pricing will rebound – not to $100 a barrel granted, that’s probably over for good –  but to around today’s level.

This assumption rests on the notion that what could happen in the second quarter will again be temporary because of high US inventory levels, the end of cold weather in the US and refinery turnarounds.

But first of all, you need to ask yourselves this question: Why exactly did oil prices recover in February?

The rally appears to have been driven by oil traders who made use of misleading stories about US rig counts .Although the number of rigs in operation in the US has fallen, production has continued to increase.

“Oil investors are making money buying and storing oil because of the difference between the current price of oil and the price of delivery in far-off months,” wrote the Associated Press in this 4 March article.

You then need to take into account these arguments:

  • Oil supply will not be turned off as quickly as many people think. In the US, for example, a few dollars above variable cost margins on a barrel of oil are better than no dollars at all when you have large debs to service. Saudi Arabia is also playing the “long game” as it tries to win back market share. This reduces the chances of an OPEC production cut.
  • Demand is the thing. Yes, a lot more money is now in the pockets of consumers because oil is cheaper, but when deflation takes hold, people spend less rather than more money. It is very hard to make the case that deflation today is not a major global problem.
  • And once again it must be stressed that this is not “business as usual” in China. The problems with China’s economy will take many years to be fixed. The global consequences of this reform process are huge.
  • And on the subject of supply again, supply of energy is vastly above demand because central bank stimulus so badly distorted our view of real, underlying demand growth. As energy-company debts left over from this critical mistake are restructured, this will add to global deflation.

So what is the right price for oil?

The chart above, from this ICIS article by fellow blogger Paul Hodges, is helpful in trying to answer this question. It shows that the long term average price of crude since 1861 until 2013 was actually just $30 a barrel, inflation adjusted.

You would be very unwise not to at least build $30 a barrel into your scenario planning.

And you would be very, very unwise indeed not to plan for extreme volatility in oil prices over the next few months and years, as the world adjusts to its New Normal – whatever you think that New Normal is.