Since oil began its precipitous fall in 2014 (at writing, Brent Crude is trading 74% below its highs of that year), the drop in commodities prices has garnered extensive media coverage. Despite headlines focused on daily price fluctuations, FSG has not seen the overriding global energy fundamentals change since prices began their initial descent. Instead, it is the understandably negative sentiment around global energy markets that has continued to drive prices well below analyst estimates. Accordingly, in January FSG revised its energy price view from an average $50 per barrel in 2016 to $30-35 per barrel.

Why are energy prices so low?

In the long term, supply and demand drives the price of any asset, and energy – despite unique considerations such as storage, regulation, and extraction – is no exception. Viewed through this lens, we can see that this price rout has been driven by global supply far outstripping demand. A combination of separate shocks have conspired to drive this marked supply-demand imbalance.

Strong dollar incentivizes higher production: Since signaling to the market in 2014 its intent to raise rates, the dollar has strengthened considerably against almost all global currencies. As energy assets are priced in US dollars, this means that local producers have had a higher incentive to produce than before, as the strong dollars they receive from the sale of an asset can be exchanged for more local currency. Even as the dollar price of energy has fallen, in most cases local currencies have depreciated by even more, preserving the benefit of the sale of a dollar-priced asset. In markets where the acquisition of foreign reserves is dependent on the sale of oil (Nigeria and Russia, for example) the macroeconomic incentive to produce despite low prices has persisted, for domestic supplies of hard currency would otherwise be completely drained.

Low-cost producers can continue to produce: Low-cost producers, such as Saudi Arabia, have accumulated quantities of foreign reserves that are large enough to protect their economies even as the price of their dominant asset falls. Even these producers will feel the pinch in 2016 – we have seen some countries cut subsidies to businesses and households, and consider raising funds through other means – but in general, they should remain well-protected.

US shale technology limits political disruption: US producers can bring shale wells online in only 3-6 months, substantially faster than the 3-5 years required for traditional wells. This significant technological development has affected price, not only in terms of increasing total supply, but also by mitigating the impact of political supply disruptions through more responsive operations.

Why not $20 per barrel?

If the fundamentals of energy favor low prices so strongly, then why have we changed our energy price forecasts to $30-35 per year, and not lower?

High-cost production is coming offline, reducing long-term supply: Higher-cost producers are beginning to reconsider and even cut longer-term investment in higher-risk extraction projects. The higher-cost and longer-term the project – such as deep water and oil sands – the more likely the project will be cancelled. Falling investment reduces future oil supply, which will support higher prices.

Some producers would cave with prices sustained below $25 per barrel: FSG analysts anticipate that some oil producing countries, such as Russia and Venezuela, which have not diversified extensively beyond oil and state-owned industries, would not be able to tolerate oil prices sustained below $25 per barrel. Producing energy near or at a loss would not be tenable. As a result, these countries would be more likely to reduce production in an effort to increase energy prices.

Global demand will improve: In the long term, global economic growth will improve, increasing demand for energy and gradually making up for what has been relatively low demand in global energy markets.

Why not $60 per barrel?

As US shale producers begin to show signs of financial trouble and many higher-cost producers cut production, why do we not see energy prices rising in the next 1-2 years?

Global production is still very high, as per our comments above.

The US energy industry will not collapse: Although FSG does anticipate some smaller US energy firms to file for bankruptcy in 2016, we expect industry consolidation rather than collapse. Larger US producers have signaled the intent to continue producing as long as possible, even as they cut capital and operating expenditures. And the US energy industry, while important, is not nearly as systemically linked to consumption, the major engine of the US economy, as housing was in 2007 and 2008. US banks are well capitalized and monitored, shielding them somewhat from the impact of loan losses.

Global energy storage levels are also very high: Each the US and Saudi Arabia have about 500 million barrels of oil in storage. Oil storage in the United States can fuel its own consumption for almost two months, unaided. Such high storage mutes the impact of political disruptions or news of smaller countries cutting back.

New sources are due to come online: While we anticipate that Iran’s crumbling energy infrastructure will result in lower production than once estimated, new sources of energy will continue to put downward pressure on prices.

Looking ahead: signposts to watch

Our annual average energy price forecast of $30-35 per barrel does not tell the whole story. In fact, we expect substantial volatility to continue throughout 2016. Companies can consider the following global guidelines when stress testing their own energy price assumptions:

• Watch for drivers of US dollar strength: Whenever the US dollar has strengthened, the price of oil has fallen. Watch for hawkish (favoring higher interest rates) rhetoric from the US Federal Reserve and good US jobs and inflation reports to signal lower energy prices.
• Look out for China: Poor economic data out of China has also had a swift impact on energy and other commodities prices. As China’s government manages the country’s transition from an investment-led to a consumption-led economy, anticipate that indications of lower Chinese demand will put sharp, if not sustained, downward pressure on commodity prices.
• Plan for currency movements: A strong dollar not only contributes to lower energy prices, but also necessarily means weaker emerging market currencies. The trend in 2015 was for depreciation of emerging markets currencies against the dollar. In 2016, we expect currency movements to be more volatile than the largely one-directional depreciation of emerging markets currencies that companies experienced in 2015. Volatility puts pressure on governments that try to stabilize their currencies, and will continue to weigh on foreign exchange reserves.

• Monitor subsidy cuts globally: Lower commodity prices mean lower revenue for exporters and lower bills for importers. Governments that import energy thus are able (or are forced) to reduce subsidies to households and businesses while avoiding the popular unrest that would typically follow subsidy reduction. The reduction of these subsidies can swiftly alter the cost assumptions that companies face in emerging markets.

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