After a strong rally during the opening months of the year, the oil market has come under renewed downward pressure. The biggest cloud in the sky is mounting worries about demand erosion, which offers awkward reminders s of what happened in 2008 when global oil consumption contracted by 4 million barrels per day (mbbd). The main risks now emanate from Europe, even if the better-than-expected election result in Greece may have offered something of a respite. This anxiety has been further fueled by more disappointing US data and indications that growth is also fairly consistently slowing down in the key emerging markets. This matters because they serve as the main source of oil demand growth globally. These negative trends will likely fuel recurrent volatility in the coming weeks and months. In an extreme case of a shock triggered by a major euro zone crisis, bearish market sentiment would almost certainly at least temporarily bring prices down to a new, much lower range.
However, prices are not a factor of demand alone and the supply side story provides a number of complications. Structurally, the oil market remains tight: As demand from the emerging markets continues to rise, albeit more slowly than before, the marginal cost of production of oil is increasing. New hydrocarbons resources are increasingly challenging in nature. Tapping the unconventional North American fields for instance will necessitate triple digit prices and will run into considerable resistance on environmental grounds. The main non-OPEC producer, Russia, is seeing its onshore fields depleted at an accelerating pace while the Arctic offshore fields are much more expensive to exploit and unlikely to begin to make a difference before 2020.
A potentially significant near-term disruption for the oil market is the implementation of the Iranian embargo on July 1. The ongoing negotiations on nuclear facilities are making little progress and there is clamoring in the US Congress for even tighter measures. While the effectiveness of the sanctions in Asia may be limited, there are instances of compliance. Saudi Arabia can make up the shortfall for now, but attempts to replace Iranian oil may have significant implications for prices. Moreover, efforts to source more oil from other producers appear to have met with limited success, partly because of supply side problems in key countries such as Venezuela and Nigeria. Even if China and India do end up eventually boosting their purchases from the Islamic Republic, Iran is to an extent being hit in the areas of shipping and international funds transfers.
Even the deteriorating economic outlook has an upside as far as the oil market is concerned. It is once again leading policy makers to consider new stimulus measures which will under the current circumstances likely have to involve a great deal of unorthodox monetary easing with positive implications for commodity prices. Even in China, the People's Bank has already started reversing some of its previous tightening moves. The main potential risk here would be the reduced effectiveness of such stimulus in the face of a major demand shock, given that the fiscal toolkit is a lot emptier than it was four years ago.
All these factors taken together may yet put renewed upward pressure on the oil price even as demand erosion concerns likely persist. Even if prices rebound, however, there are powerful arguments for trying to contain the volatility. The rising production costs and growing fiscal dependency of many producer nations on higher prices limit the room for downside correction which at a minimum would threaten the necessary new investments as happened in 2008. Conversely, prices much above $100 would be bad for the global recovery and benefit alternatives. This in part explains the recent OPEC rhetoric for price moderation. Of course, lower prices would be brought about through increased production which where volumes increases would compensate for the price losses.
— Jarmo T. Kotilaine is chief economist at the National Commercial Bank, Saudi Arabia.
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