What is the New Floor for Oil Prices?

A recent poll by Reuters showed 22 of 32 analysts expect Brent futures to price at $100 a barrel or above next year despite demand concerns from a Euro zone collapse and poor economic data in the US. It seems that $100 a barrel for Brent is now considered the new floor for oil as it is supported by rising production costs and social costs.

There is no need to focus on production costs for oil producers all over the world. Suffice to say production costs have been rising thanks to inflation and to new production coming from increasingly expensive sources (Ultra deep water, unconventional and oil sands). All we need to do is focus on the breakeven costs for 2 of the largest producing countries: Russia and Saudi Arabia. For Saudi Arabia, the social break even cost is around $80 per barrel. The social cost in the Middle East can be translated into “buying peace” from the local population through increased social spending and this not only applies to Saudi Arabia but also to the remaining Gulf kingdoms such as Kuwait. This is the easiest way to avoid an “Arab spring” in your realm and some countries are already going overboard. For instance, the IMF is asking Kuwait to cut spending or risk running out of oil money! Furthermore, according to a report from Emirates NBD last month, the UAE’s break-even price for oil has risen to US$107 per barrel.

Thankfully, with oil futures there’s no need to determine yield to worst (ytw) as it is not an option. The main difference is that a counter party cannot close out a futures contract early. You can get out of a futures contract, but you’ll need to take an opposing position.

Let’s focus on Saudi Arabia a bit as they are one of the top oil producers in the world currently pumping 10 million barrels of oil per day. The Saudi’s can and do manipulate their production in order to influence oil prices. They act as a central bank for the oil sector by increasing and lowering production levels according to price gyrations. The Saudis made it clear many times in the past months that $100 Brent oil is their sweet spot and it’s not surprising since this level is profitable, covers their social spending and avoids damaging the global economy. If oil falls substantially below that level, the Saudis will react by cutting their production. Why should they sell their oil for less? If Saudi Arabia can play the oil banker, Russia which also produces 10 million barrels of oil per day can play the game as well. Reuters reported in March that Russia’s social break even cost for oil was at $117 per barrel for 2012!

Saudi Arabia is an interesting case because of its geopolitical location. The country is in bed with the US in a mutually beneficial relationship, I scratch your back and you scratch mine. The US helps keep the big bad wolf at bay (Shiite-Iran)  thanks to multiple military bases in the region. In return, Saudi Arabia can and does play an active role regarding oil prices if a political decision is taken in that regard. Lowering Brent oil prices to $100 is in Saudi’s interest (doesn’t kill the golden egg laying goose) and benefits the current US administration through lower gas prices at home.

What does $100 Brent oil means for North America? If the WTI-Brent differentials hold at around $20 per barrel, it means WTI oil is heading to ~$80. On the other hand, WTI oil would have a ~$20 upside as pipeline projects come online alleviating storage concerns at Cushing in the coming months.

For other large oil producing countries, $100 Brent oil can mean a lot to their GDP. The effect is mainly found in the Net Exports formula, which is one component of GDP. For the rest of the world, oil prices can have a huge impact on expected inflation. If you’re using the Fisher Effect Equation to work out the expected risk-free rate, then expected inflation will play a major role.

Obviously, we’re not living in a perfect world where oil will settle at $100 for an extended period of time, oil prices are volatile reacting to the slightest distortion in demand/supply fundamentals or to perception of risk. In fact, if the price drops significantly, then many companies calculating inventory at the lower of cost or net realizable value  would see their balance sheets take a hit.

I keep repeating that while the price can CRASH on the back of a blow up in the Euro zone or a global recession, it would only be for a limited time. Low prices would not last because other countries in addition to Saudi Arabia will react swiftly by cutting their production. The cuts would support a gradual increase in the price of oil as the dust settles just like in 2008-2009. This scenario will keep on repeating itself as long as there is no alternative in the form of a cheap and abundant energy source.

While the floor price can be easily shattered, the long term trend for oil prices is up. This year, according to the IEA demand for oil is expected to rise 1%. This is DESPITE having the EU on the brink of collapse and 8% unemployment in the US.

Where do you think oil is heading?