Oil Glut or Oil Cut?
A Scenario Approach to Envisioning Oil Prices in 2015–2016

Jenik Radon Esq
Adjunct Professor, School of International and Public Affairs, Columbia University

Genevieve Signoret
President and Head - Asset Allocation, TransEconomics

We present two scenarios for oil prices and the global economy over the next two years. In one, OPEC does not act (cut output) to stabilise prices. Brent dips to USD 60/barrel in 2014, but, by the end of 2015, starts to rebound. In our second scenario, OPEC does cut output. At first, this succeeds: Brent quickly climbs back up to USD 90. By the end of 2015, however, Brent again starts sliding. Our stories illustrate how, regardless of policy, oil prices over the long run tend to self-correct. They also show how OPEC may hold some sway over the timing of the Fed's first rate hike.

After plunging in 2008 from their July 14 bubble peak of USD 142/barrel (Brent) down to USD 34/barrel on December 26, global oil prices recovered to a new equilibrium around USD 100/barrel. Since July of this year, however, they show signs of entering a new phase. Brent crude has dropped 27 percent and is still falling. Business leaders and investors have no choice but to formulate views on what this new oil price phase might look like. It's a daunting task, one we tackle by limiting our forecast horizon to two years, and by adopting the scenario approach.

Why the Scenario Approach?
Life is unpredictable. Hence, forecast accuracy is a pipedream and risk a constant. Risk management is the only way forward. A power tool for coping with risk and uncertainty is scenario-based planning2.

To build alternative scenarios for the global economy and oil prices, we start by gathering an interdisciplinary team to develop two or three clusters of assumptions, one for each scenario. These cover unpredictable oil price drivers that we won't be modeling: policy, politics and geopolitics, weather, and pandemics. Upon each cluster of assumptions, we build a rich scenario narrative and a forecast model. The scenario we deem most plausible we dub 'central scenario'; the others we call 'risk scenarios'. Once having built the scenarios, either with or for clients, we can formulate strategies designed to be robust under all scenarios. Periodically, we update our tool by repeating the exercise.

OPEC—and Specifically Saudi Arabia-are Drivers
A good oil price scenario will require assumptions as to OPEC and Saudi behavior. While, owing to the shale boom, OPEC’s market share has slid recently to 39.9 per cent and is expected to drop3 by 2018 a further 2 percentage points to 37.9 per cent, OPEC output generally and Saudi output specifically remain strong drivers of oil prices. Saudi Arabia's special leveragederives from its outsized spare capacity.

Saudi Arabia Aims and Future Tactics are Unknowns
Theories abound as to Saudi intentions and coming chess moves. One popular story circulating is that Saudi Arabia aims to regain OPEC market share by persuading its fellow cartel members to refrain from cutting quotas and actual output and thus keep prices down.

In more conspiratorial versions, Saudi Arabia targets an oil price just low enough to put small US shale oil producers out of business or to exact vengeance on Russia for its loyalty to Syrian President Bashar al-Assad.

While these theories make for racy reading, the fact is, actual Saudi aims and future tactical moves are unknowable. To be able to plan, we can only make plausible 'assumptions' as to what Saudi Arabia might do and why, and basedthereon, compute projections.

Two Sets of Assumptions as to OPEC Behavior
Our central scenario, called 'Oil Glut', assumes that OPEC decides not to cut output. Saudi Arabia seeks this and extracts the decision at OPEC. It assumes, further, that dissenting OPEC voters either don't try, or they try but fail, to form coalitions for coordinated cheating.

We mention coalitions for cheating because our devious minds detect a potential for multilateral cheating should OPEC decide not to cut quotas. Saudi Arabia may deem it can afford low oil prices fiscally. But several other OPEC producers may well not-few have much spare capacity, so most can't make up in volume for losses caused by falling prices. If Saudi Arabia has its way, then, a rebellious coalition could form-a cartel within a cartel-to coordinate an output cut.

Evidence abounds of 'unilateral' cheating by OPEC producers through production in excess of quotas. Here the cheating we envision is multilateral (coalitionbased), and works in the opposite direction, through underproduction.

Under Oil Glut, we assume that no such cheating occurs-Saudi Arabia wins not only the vote but also hearts and minds.

Additional Scenario Assumptions
We make the following additional assumptions under both scenarios:

Weather and Conflict: No weather event or conflict materially restricts or threatens oil or other commodity supplies. Notwithstanding intermittent spikes in Russia–Ukraine tensions, Russia never cuts off gas to Europe via Ukraine. Market fears raised at moments of spiking Russia–Ukraine tension remain contained—they never spill over to oil markets. Diplomatic and trade relations among China, Japan, and Korea continue to thaw.

Policy: Chinese authorities manage to avert an outright financial crisis. Central bankers do not err: the Bank of Japan (BoJ) keeps up its asset purchase (quantitative easing) programme, and the European Central Bank(ECB) launches a second round of quantitative easing, this one targeting public debt securities as well as private ones; and both the US Federal Reserve and the Bank of England are careful not to raise interest rates prematurely. In fiscal policy, Japan smartly postpones the tax hike scheduled for next year, but the euro area continues to flirt with deflation by failing to work in concert with monetary policymakers and loosen its fiscal stance. Neither Japan nor the euro area passes bold enough reforms to materially boost potential GDP or animal spirits. China does continue on its reform path, in the direction of tilting its skewed economy back toward consumption and away from saving and investment. Necessarily, this slows down Chinese growth.

Oil Glut: The Narrative
Under Oil Glut, for whatever reason, Saudi Arabia wants prices to stay low and, during the forecast period, manages repeatedly to sway OPEC opinion against output cuts. Moreover, no rebellious coalition emerges that's capable, through coordinated cheating, of pushing oil prices back up. Brent oil falls to a new equilibrium around USD 60.

Although oil exporting countries suffer, most OECD countries enjoy what economists call a 'Goldilocks' economy, in which inflation slows down even while growth speeds up. Disinflation frees the Fed and the Bank of England to postpone rate hikes to early 2016. By this time, UK and US labour markets and domestic demand indicators are so healthy that financial market shrug off the hike. The bull market continues.

By the second half of 2016, demand for oil has begun to surge. But low prices have taken their toll: some smaller US shale producers were forced to shut down, while new investment in infrastructure and ongoing projects were put on ice. Together, these renewed demand- and supply-side pressures push back up on prices.

By December 2016, Brent has bounced back to USD 70 and continues to climb.

Oil Cut: The Narrative
In Oil Cut, OPEC votes to cut production quotas and cheating becomes impossible. In the short run, this strategy bears fruit: Brent crude bounces back to around USD 100. In the medium term, however, it backfires. With oil prices recovering in 2015, the Fed and the Bank of England cut rates in June. Even though these two central banks normalise rates slowly, the rate hikes slow the global economy back down. With growth (and demand for oil) again moving at a snail's pace, by the end of the forecast period, prices again slide.

2016 ends with Brent already back down to USD 90 and falling fast.

Commodity Markets Self-correct
Our stories have two morals. First, energy markets self-correct. Falling prices spur demand and lure producers back online, causing prices to recover. Rising prices do the opposite. Second, low oil prices could end up giving the Fed and Bank of England room to maneuver in inflation space to postpone hiking rates. The delay can provide so much stimulus as to end up boosting oil demand and prices both.

Reference
  1. Moisés Arizpe of TransEconomics provided valuable research support.
  2. Our approach is an adaptation of the Shell approach, as laid out by Peter Schwartz in The Art of the Long View: Planning for the Future in an Uncertain World, and Kees van der Heijden in Scenarios: The Art of Strategic Conversation.
  3. http://www.reuters.com/article/2014/11/06 /us-opec-outlook-idUSKBN0IQ22H20141106