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Crude prices have fallen 15% in three months

Lower oil demand growth and higher production rates have pushed the oil price down

Brent crude prices have fallen nearly 15% over the past three months, from around $113 per barrel (b) in late June to $96.65/b on 23 September. Weak oil demand, especially from China, and new supply from the US have both helped to drive prices lower. So, how much farther can oil prices fall? Bernstein Research, a price bull, has put the floor at around $90/b.

Bernstein looked at seven factors, which would either boost demand or cut into supply, that it reckons will act to keep prices above $90/b. "Adding together their effects, we estimate the oil market would tighten by a full 1.5 million barrels per day (b/d), if oil price fell to $90/bbl Brent, which in turn would add $10 to $25/b to the oil price, bringing us well back above $100/b," Oswald Clint, an analyst at Bernstein, wrote in a note to clients.

The most significant factor would be a rise in demand from China to fill its strategic stocks. Bernstein plotted China's inventory changes against the oil price and found that Chinese companies have acted quickly to boost purchases during recent periods of oil price declines, most recently in June and July 2012. "The inverse correlation between oil prices and Chinese purchases highlight that China's purchases accelerate when oil prices fall, whereas purchase scale back as oil prices rise," Clint wrote.

There is some evidence this is already happening. In early September, state-owned Sinopec's marketing business Unipec booked a 3.2 million barrel Ultra Large Crude Carrier to store crude at sea. Bernstein reckons Chinese demand, which has been lower than expected this year, could rise by 500,000 barrels as the country takes advantage of lower prices to boost inventories.

Bernstein also argues that lower crude prices would see a rise in US fuel demand as prices at the pump fall. "US vehicle miles travelled is the key determinant of demand for gasoline and correlates inversely with the oil price," says Clint. Bernstein calculates that a $90/b Brent crude price would see US gasoline prices fall by around 10% from its current average of $3.48 per gallon. That would add around 130,000 b/d to expected demand, Bernstein argues.

Likewise, Europe would see higher-than-expected demand during a sustained period of relatively low oil prices, though it wouldn't be enough to reverse the region's declining trend in overall consumption. Bernstein says European buyers would add 50,000 b/d to 110,00 b/d of additional purchases as they looked to take advantage lower prices to build stocks.

On the supply side, Opec looms larger as prices fall lower. The cartel's governments have increased domestic spending in recent years on the back of higher oil prices, which means most governments now need an oil price of at least $100/b to pay their bills.

Opec oil output is higher than its stated 30 million b/d ceiling, which has helped contribute to a relatively comfortable supply level for the oil market. But that could change. "If oil prices fell to $90/b we expect Opec to enforce the 30m b/d production ceiling, and agree to reduce its output closer when the group meets in Vienna on November 27th," says Clint. Last month, Saudi Arabia cut its production by more than 400,000 b/d. Bernstein reckons Saudi could cut its exports by another 200,000 b/d if prices fall to $90/b.

Lower prices would also hit production outside Opec. Bernstein points in particular to marginal oil wells in the US, mostly stripper wells that produce less than 15 b/d, and mature fields in Norway's section of the North Sea that would likely become uneconomic and be taken offline if oil prices continue to decline. These are small wells, but there are a lot of them and the cumulative effect would be felt in the market. Combined, 150,000 b/d of oil could be lost from these wells at $90/b, Bernstein says.

Combined, the above factors would result in a 1.5m b/d tightening of the oil market, roughly equivalent to the amount of production lost when Libya's civil war shut down the country's oil industry. Moreover, it does not get into potential disruptions to other high-cost oil plays such as Canada's oil sands, US shale oil or marginal Russian production, which could all reduce production further.

Bernstein has forecast Brent will average $111/b this year, and is standing by that prediction in spite of recent declines. However, further weakening of Chinese demand or higher-than-expected increases from the US' shale oil patch could support lower prices. "The key conclusion is that major dislocations in the oil price from marginal cost feel unlikely to us, given the elasticity we find in the system today," says Clint.

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