Operations At An Orion Drilling Co. Oil Platform
Photograph by Eddie Seal — Bloomberg via Getty Images

How low can oil go?

Jan 05, 2015

The American consumer got a surprise gift this holiday season: the dramatic collapse in the price of oil. The trend has sent gas prices down to a national average of under $2.20 per gallon, with rates under $2 per gallon in some states.

The benefits of cheap gas are widespread, though the price declines are more of a mixed bag for economies in U.S. states with large energy sectors.

Oil prices have continued to fall into the new year, as the price of a barrel of U.S. light crude oil fell below $50 on Monday for the first time since early 2009. So, just how low will oil go?

Edward Morse, global head of commodities research at Citigroup, argues in a research note to clients published Sunday that we've probably already reached a market bottom and that oil prices will begin to rise in the latter half of the year as producers finally begin to curtail supply. He puts into context just how profound the collapse has been, writing:

Average Brent prices are now trading some $55 a barrel lower than they were from Q1’11 through Q2’14. That’s a $4.4 billion daily drop in the costs of oil, discounting for the more than 10% of global oil consumption not fully priced into market levels. For the world as a whole, annualized, it amounts to about a $1.6-trillion quantitative easing program for the world economy, but an equal loss of revenue for oil producers, sovereigns and companies alike.

But Morse argues that this trend will start to slow during the first half of 2015, and that prices will rise sometime in the second half of the year. As you can see from the chart below, Morse sees the price of U.S. crude, also known as WTI, bottoming out in the second quarter at around $47 per barrel, and increasing from there.

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So, what might cause an oil-price bounce back? There are certainly plenty of forces pushing oil prices the other way, namely a significant slowdown in the growth of China's economy, coupled with a steadily increasing energy supply brought on by innovative methods for extracting oil from shale deposits. Indeed, several new pipelines like Enbridge’s (enb) Flanagan South line, which is capable of pumping 600,000 barrels per day from Illinois to Oklahoma, began pumping oil or added capacity late last year. This has allowed even more of Canada's vast oil deposits to hit the global market in a cost-effective way.

But suppliers will eventually have to respond to lower prices. Beginning in late 2015 and into 2016, Morse argues that drillers will start abandoning their less productive operations, which will result in slower growth in global oil supply.

Of course, geopolitical events can throw off these projections. Few sectors are as intertwined with international politics as the oil market, and already we're seeing price declines have significant effects on events in Russia and Eastern Europe as well as places like Venezuela and Iran. In particular, Morse worries that cheap oil could lead to severe instability in countries like Venezuela and Libya. Upheaval in oil producing regions could limit production and therefore send oil prices higher.

But Todd Mariano of Renaissance Macro Research thinks that if history is any guide, lower oil prices will yield positive, long-lasting effects. He says that the price decline we're experiencing today "bears a striking resemblance to 1986," when global oil markets also crashed and had wide-reaching effects on geopolitics and the global economy. The collapse in oil prices in the late 1980s played a role in bringing the Iraq-Iran war to a close, as both countries relied on oil revenues to finance that conflict. A similar dynamic could unfold in Russia, as reduced government revenues might make Putin's adventurism abroad less feasible.

The most striking quality of the mid-eighties decline in oil prices, however, was how persistent it was. As Mariano writes, "Leaving aside the spike related to Iraq's invasion of Kuwait in 1990, [U.S. crude oil prices] in nominal terms had still not recovered its late 1985 levels fifteen years later, in 1999."

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In other words, if developments in today's oil market are, in fact, a replay of the mid-1980s, relatively cheap oil might be here to stay.

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