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IEA: The oil market no longer behaves the way it used to

The International Energy Agency (IEA) is supposed to be the world's leading expert on energy markets. Its analyses of crude oil prices and supplies make headlines, roil Wall Street, and shape how policymakers see the world.

And right now, the IEA is a little baffled.

"Attempting to understand how the oil market will look during the next five years is today a task of enormous complexity," the IEA said, almost apologetically, in its latest Medium-Term Oil Market Report. "Some certainties that have guided our past outlooks are now not so certain at all."

Here's the main issue: Over the past two years, crude oil prices have utterly collapsed. Back in June 2014, it cost more than $100 to buy a barrel of Brent crude (the main global benchmark for oil prices). Today it costs just $34, the lowest level in more than a decade:


That collapse was a shock at the time, though most analysts now broadly agree what happened. For much of the 2000s, crude demand was rising fast, and supplies struggled to keep up. Prices soared. Those high prices, in turn, made it profitable for companies to extract oil from hard-to-reach places like the shale formations of North Dakota and Texas. Then global demand started sagging. And pretty soon, there was a supply glut — causing prices to crash. (I've simplified a bit, but the full story's here.)

The real puzzle, however, is what happens next. And this is a really difficult problem for the IEA. Because many of the old assumptions about how oil markets work no longer seem to apply.

The past two years have upended three big assumptions about oil markets

Let's step back for a second and look at the chart below. Ever since 2014, the world's producers have been pumping out far more oil than anyone needs. Oil production (in green) is outstripping consumption (in yellow). The rest gets stored in stockpiles (blue):

(<a href="">International Energy Agency Oil Market Report</a>)
(International Energy Agency Oil Market Report)

Normally when this happens, you'd expect an adjustment. Low oil prices should cause producers with high costs to cut back on drilling. Cheap oil should give consumers incentive to use much more of it. Eventually supply and demand should come back into balance, and prices should stabilize or even rise again.

But events haven't transpired in quite the way everyone expected. The IEA notes that, a year ago, many analysts predicted the market would come into balance by late 2015. "That view proved to be very wide of the mark." Instead, oil prices kept plummeting.

Basically, three unexpected things happened:

1) US oil production proved more resilient than anyone expected. It's expensive to extract oil from shale rock via fracking in places like North Dakota and Texas; the wells deplete quickly, and you have to keep drilling new ones. So many observers figured low oil prices would throttle output there. But instead, US shale drillers managed to slash costs and boost their productivity. Yes, many of these firms are now facing serious financial pain. But the oil's still flowing. US crude production is down only slightly from 2015's record highs:

(US Energy Information Administration)

This doesn't just apply to shale. In the United States, offshore production has reached record highs in the Gulf of Mexico, despite low prices. The IEA notes that various technological advances are relentlessly driving down drilling costs, making oil supplies more resilient to price drops.

2) OPEC hasn't really tried to prop up prices. In the past, when oil prices plunged, OPEC countries like Saudi Arabia often worked together to cut back on output in order to prop up prices and keep their budgets in the black. This time, that hasn't happened. Instead, OPEC's members have been ramping up output in a frantic fight for market share.

Russia and Saudi Arabia are now pumping crude oil at record levels. Iraq has doubled oil production since 2014 as it recovers from war. Iran is starting to bolster exports now that US-Europe sanctions have been lifted. And there's little hope this will change. A recent overture by Russia and Saudi Arabia to freeze production hasn't (yet) persuaded the rest of the cartel to follow suit. And none of OPEC's members are contemplating actual production cuts.

3) Oil demand hasn't surged as fast as expected. Again, when prices are cheap, you'd expect oil demand to soar. But demand growth has been (relatively) sluggish in recent years. Much of that is due to ongoing economic torpor in China and Europe. But some developing countries are also starting to pare back fuel subsidies in order to alleviate strains on their budget. And many countries are considering efficiency measures to cut back on oil consumption for environmental reasons.

Add those up, and global oil markets no longer work quite the same way they used to. That makes predictions harder. Here's the IEA again:

Some certainties that have guided our past outlooks are now not so certain at all: that oil prices falling to twelve-year lows will lead to a strong demand growth spurt; that oil prices falling to twelve-year lows will lead to a mass shut-in of so-called high cost oil production; and not least that oil prices falling to twelve-year lows will force the largest group of producing countries to cut output to stabilise oil prices.

So what happens next? Here's the IEA's best guess.

With those lessons in mind, the IEA is now hazarding a fresh guess for what happens over the next five years. With the caveat, of course, that predictions are hard and very often wrong.

The bottom line: In 2016 and 2017, the IEA expects production to continue to outpace demand. Barring something unexpected, like a fresh conflict in the Middle East, "it is hard to see oil prices recovering significantly in the short term from [current] low levels." Cheap oil is likely to stay with us for another year or two, at least.

But the agency also warns that this situation may not last forever. Low prices will lead to less investment in new production capacity over the next few years. Yet global demand is expected to keep rising during that time. So at some point in the future, demand is likely to outstrip supply again. When that happens, the failure to invest in new capacity could lead to supply disruptions and the return of spiking prices:

(International Energy Agency)

"It is easy for consumers to be lulled into complacency by ample stocks and low prices today, but they should heed the writing on the wall: the historic investment cuts we are seeing raise the odds of unpleasant oil-security surprises in the not-too-distant-future," IEA executive director Fatih Birol said in a statement.

More specifically, the IEA is predicting:

1) Oil supplies will rise by about 4.1 million barrels per day between 2015 and 2021. That's a much slower pace than the 11 million barrels added between 2009 and 2015. Iran and Iraq will keep increasing production, though new investment will be limited by "political uncertainties" in both countries.

The US is expected to see a modest drop in shale production this year as low prices bite — a loss of about 600,000 barrels per day in 2016 — before output eventually rises again as prices nudge upward. Many officials now think a big chunk of shale production will come back online when prices get back to $50 or $60 per barrel.

2) Global oil demand will grow at a modest pace, around 1.2 percent per year, through 2021. The IEA doesn't expect demand to surge more rapidly than that in the near term, in part because the global economy has a lot of soft spots, and in part because many developing countries (where most demand growth is happening) are expected to take steps to reduce fuel subsidies and curb vehicle use to reduce pollution.

3) Thanks to low oil prices, investment in new production capacity will keep falling. The IEA expects a drop of 24 percent in 2015 and 17 percent in 2016. Budget-strained countries like Nigeria, Venezuela, and Algeria will see a particular crunch. By the end of the 2015-2021 forecast, this lack of investment could lead to supply shocks and possible price spikes. "The risk of a sharp oil price rise towards the later part of our forecast arising from insufficient investment is as potentially de-stabilising as the sharp oil price fall has proved to be."

Now, could those predictions be wrong? Of course. It's possible, for instance, that the IEA has overcorrected for the lessons of the last two years. Perhaps US shale production will collapse more sharply than expected. Perhaps demand will end up surging. Or perhaps something different entirely will happen.

Ultimately, the IEA concludes, oil markets are in somewhat uncharted territory, which makes projections about the future particularly difficult. The fact that OPEC members are no longer coordinating to stabilize prices — but are instead pumping out as much as they can to maintain their market positions — has led to an entirely new oil era:

In 2016, we are living in perhaps the first truly free oil market we have seen since the pioneering days of the industry. In today’s oil world, anybody who can produce oil sells as much as possible for whatever price can be achieved. Just a few years ago such a free-for-all would have been unimaginable but today it is the reality and we must get used to it, unless the [OPEC] producers build on the recent announcement and change their output maximisation strategy.

"The long-term consequences of this new era," the agency concludes, "are still not fully understood."

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