Oil's wild ride in 2014 signals return to volatility

After five years in which oil traded in a narrow band around the $100 US a barrel mark, crude markets returned to volatility this fall. Analysts have no consensus on how low it could go, but they're ready to predict a pullback in investment.

Prepare for cutbacks in investment as producers wait for demand to pick up

An oil pump works at sunset in the desert oil fields of Sakhir, Bahrain. OPEC can afford to wait out falling oil prices because of its low production costs. (Hasan Jamali/Associated Press)

After five years in which oil traded in a narrow band around the $100 US a barrel mark, crude markets returned to volatility this fall.

Back in late June of this year, oil was trading at $107 US a barrel. At year end, it was headed below $54 a barrel.

The months in between tell the story of how changes in supply and demand can lead to wild and unpredictable swings in the price of a commodity.

Geopolitical tensions earlier this year had the effect of pushing oil prices to a peak. It pushed through $100 a barrel in March because of tensions in the Ukraine and then in June, ISIS moved in on oilfields in Iraq, threatening to cut off supplies. Crude hit a peak for the year of $107 a barrel for the West Texas Intermediate contract.

After many years of being the top performers in the country, the resource-rich provinces are going to experience significantly slower growth and so the oil patch is going to suffer quite significantly- TD  Bank chief economist Craig Alexander

But this summer, markets began to see the downturn in Europe and Japan were worse than previously realized. At the same time, emerging markets, particularly China, began to lose steam after propelling global growth for the past five years.

“We are seeing significantly slower growth in the emerging economies around the world, so the global economy isn’t growing at a very strong pace and this is the initial reason why oil prices started to fall,” says Craig Alexander, senior economist with TD Bank.

OPEC and supply

On the supply side, the OPEC oil cartel, which uses its production quota to manipulate prices, was keeping production level in the face of interrupted supply from some of its members, including Libya and Iraq. On Nov. 27, OPEC said it would maintain that level at 30 million barrels a day despite a world oversupply of oil.

Over the past five years, the high price of oil has encouraged investment in a lot of non-conventional sources of crude, including oilsands and offshore oil. But the biggest change was the growth of U.S. shale oil, which was being pumped at such record output that U.S. oil production hit a 45-year high.

A glut of supply and a reduction in demand are the recipe for lower prices and that’s exactly what we’ve seen this fall, a 45 to 50 per cent drop in oil prices.

“The initial drop that we saw in oil from $100 to the low $70s was actually fully justified on grounds the world economy was so much weaker,” Alexander said.

“I think the drop we’ve seen from the low $70s to below $60, that’s actually been more of a story about the fact that we haven’t seen a cut in supply.”

The last such steep price drop in oil was in 2008, when the financial crisis drove down demand. Since then, oil prices have been relatively stable, despite geopolitical tensions.

Where is the bottom?

As the world came out of the 2008 recession, demand for oil grew, but supply was kept in check by disruptions in Iraq and Libya and OPEC's management of the flow of oil.

Many analysts are predicting those days are over and crude markets are returning to the volatility that had been their hallmark for decades.

Predictions for oil prices next year vary from heading still lower to the $40 range to bouncing upwards to closer to $70. No one is forecasting $100 for quite some time.

Randy Ollenberger, an equity research analyst at BMO Capital Markets Canada, says oil price volatility will continue into 2015.

Oil has dropped before

“I don’t think we’re near bottom yet. My view is that world prices will probably continue to get lower here just because of the fundamentals – at this point in time we need to really see a reduction in supply and we’re probably not going to see that until the second half of the year,” he says.

He points to historic downturns in oil prices, such as we saw in 1985, 1998 and 2009. There are similarities to 1985 and 1998 in the tension that is apparent between OPEC and non-OPEC producers.

The best cure for low prices is low prices, but it takes some time to work its way through- CIBC chief economist Avery Shenfeld

Some American producers have accused OPEC of being “at war” with the U.S. industry, trying to drive U.S. producers out of the sector with lower prices.

Ollenberger doesn’t see it that way. He forecasts continued demand for higher priced oil as the world recovers its growth trajectory.

In the meantime, oil companies cannot cut off production on big projects quickly.

Companies still investing

Although some U.S. and Canadian producers have announced they will reduce their levels of investment next year, many are going ahead with long-planned projects..

Even with Western Canada Select, the price paid for oilsands oil, trading below $40 US a barrel, Canadian companies still have expansion plans, Ollenberger said. They’re planning for the future right now, though they may review their spending plans at the end of the first quarter of 2015, when they have a better handle on where prices are going.

“If you look at the large oil companies that make up the bulk of the activity levels and employment levels — Cenovus, Suncor, Canadian Natural Resources — they’re all in very strong shape, balance sheets are strong and their cash flow is underpinned by very strong assets, so they can certainly survive this downturn,” he said.

That doesn’t mean there’s not less capital going into oil investment – analysts have predicted $1 trillion could be pulled out of the sector worldwide in the coming year.

“The best cure for low prices is low prices, but it takes some time to work its way through,” says Avery Shenfeld, chief economist at CIBC.

“The loads on multi-year oilsands projects don’t really affect supply in the next year or two. We will see some pullback in areas that are much more immediate – in conventional oil, but it’s going to take some time,” he said.

Shenfeld says ISIS is still a “wild card” that could step up geopolitical tensions and impact oil supply.

And there are signs that falling oil prices are boosting growth in Europe, which could mean more demand in the year ahead.

So while OPEC still dominates the production of conventional oil, non-conventional sources such as the oilsands and offshore oil will likely be needed in the years ahead, Shenfeld said.

“When I look at the world, they’re going to need the kind of oil that Canada produces, that Brazil produces – it’s expensive oil, but it will come back,” he said.

Alberta’s oil production has been so heated over the last few years that it’s seen steep production cost rises. There is a shortage of skilled labour and housing costs are soaring.

A period of lower prices could cool that situation, though governments at both the provincial and federal level will be hurting because of lower oil prices.

“Even in places like Alberta, you’ve heard the finance minister reflecting that maybe it would be nice if Alberta’s economy wasn’t so oil-centric,” Shenfeld said.


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