For the past 150 years, crude oil prices have varied between around $10 per barrel and around $120 per barrel. For many decades, oil prices were relatively "stable" but a funny thing happened in the early 70s and everything changed - whether coincidental or causative the linkages between the oil crisis and Nixon's Gold-Standard-busting of Bretton Woods are clear in the chart below. Goldman expects continued high oil price volatility with risks skewed to the downside as the market searches for a new equilibrium... and a period of macroeconomic adjustment to structurally lower oil prices. Is oil adjusting to a new 'gold-standard-esque' normal?
As Goldman noted back in July...
The security situation in the Middle East remains highly unstable. The Islamic State (IS) has taken control of swaths of Iraq and Syria, employing brutal tactics throughout its advance. Shiite militias, the Kurdish peshmerga, and Iraqi forces have struggled in recent months to contain the insurgency. A US-led coalition has conducted airstrikes in the region since August. In Iraq, Haider al-Abadi has replaced Nouri al-Maliki as prime minister after the latter resigned in August amid political gridlock. Elsewhere in the region, the deadline to reach an agreement on the future of Iran’s nuclear program was extended until July 1, after Iran and the five permanent members of the UN Security Council + Germany failed to clinch a deal before the late November deadline. A seven-week war between Israel and Hamas militants ended on August 26 with an Egyptian-brokered ceasefire on August 26, but tensions continue to fester.
Despite the unstable situation in the Middle East (as well as in Russia), oil prices have plummeted by +40% since we published. A lack of oil supply disruptions in Iraq and Russia as well as the return of Libyan output, which relaxed near-term supply concerns, likely triggered the initial sell-off. However, major underlying drivers ultimately set the magnitude of the price decline – namely, continued strong non-OPEC production growth, weak demand growth, as well as a critical shift in the OPEC reaction function in favor of maintaining market share. Indeed, the cartel’s decision on November 27 to hold output steady signaled a major step away from its long-standing strategy of supporting prices with production cuts. Exacerbating the recent sharp price declines have been falling oil production costs given moves in other commodity prices, currencies and oil service costs, which means that oil producers can spend less to get the same or potentially even more in terms of production.
In terms of Iraqi production, as of November, Iraq was producing 3,380 kb/d, compared with a peak of 3,600 kb/d in February. At 2,810 kb/d, overall pipeline exports (2,510 kb/d from the South combined with 300 kb/d from the semi-autonomous Kurdistan region) were comparable to early 2014 levels (2,800 kb/d). Starting January 1, under a long-awaited revenue sharing agreement between Baghdad and Kurdistan, Kurdistan and the disputed province of Kirkuk will contribute 250 kb/d and 300 kb/d of their production, respectively, to the Iraqi national oil company’s exports. In return, Baghdad will release Kurdistan’s 17%share of national revenue. The Kurds will retain the right to exports above the 250 kb/d sold to Baghdad, and additional private pipeline capacity coming online makes it likely that Kurdish exports will increase over the next few months. In the meantime, independent exports from Kurdistan (of over 380 kb/d) have continued via private pipeline and by truck.
And what to look for in 2015:
Continued high oil price volatility with risks skewed to the downside as the market searches for a new equilibrium. Sharp declines in oil production costs, on top of a strong consensus view that the recent extreme oil price weakness will prove temporary (which is motivating oil producers to position for a rebound in price rather than to cut production), suggests that oil prices could fall lower and for longer. Given the expected future supply glut in oil, we believe that the market is actively looking for the new equilibrium price that will take out the excess marginal production. As the industry takes the “fat” out of the system that was built up over the past decade, the new equilibrium price is dropping sharply; where it settles is unknown right now, but we can comfortably say it is likely below our earlier estimates (Brent in the $80-85/bbl range). New cost data early next year should help narrow down what this equilibrium “new normal” might be.
A period of macroeconomic adjustment to structurally lower oil prices. EM oil importers such as India and Turkey should benefit the most, while EM exporters will face the greatest challenges, particularly in those countries with higher breakeven oil prices, such as Algeria, Iraq, and Iran.
Continued instability in the Middle East, as the IS insurgency and Syrian civil war – among other sources of conflict – remain far from being resolved. The severe extent of the oil sell-off also threatens to heighten political instability in the region (as well as in Russia and other oil producers).
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Source: Goldman Sachs