Several factors lie behind the rapid price drop, including oversupply, sluggish demand growth and the withdrawal of price supports from the financial community. And these factors are being exacerbated by the fact that the major oil producers in the Organization of Petroleum Exporting Countries have decided not to cut back production.

Oil rose to near $62 per barrel in late February, representing a price increase of more than 30 percent since January. The increase was supported by signs of lower oil industry spending, predictions of lower supply levels in the second half of the year and concerns over the escalating conflict with Islamic State militants.

The latest price surge, however, is due first and foremost to a marked increase in investor interest. This is indicated by the growing interest in the worlds largest crude oil Exchange-Traded Fund, the U.S. Oil Fund.

An Exchange-Traded Fund is a security that tracks an index, commodity or basket of assets like an index fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold. By late February, outstanding shares in the U.S. Oil Fund had soared nearly six-fold in three months, climbing to their highest level since early 2009.

Uncertain Supply & Demand

When it comes to supply-demand considerations, signs indicate a reduction of the existing supply overhang, but it is still unclear to what extent. On the supply side, a decrease in the U.S. oil rig count suggests that the countrys oil production growth will flatten out in the foreseeable future. A recent Baker Hughes report said that the U.S. rig count had dropped 24 percent since early December, hovering at its lowest level since March 2010.

On the demand side, in its short-term energy outlook published on February 10, the U.S. Energy Information Administration raised its 2015 world oil demand growth forecast by 120,000 barrels per day from its previous estimate. Despite timid signs of the market heading toward a more equilibrated supply-demand balance, there is still tremendous uncertainty about the future.

The big guessing game is whether we are now moving to a range of $60 to $70 per barrel, or whether were about to turn south again and head back below $60 or possibly even $50 per barrel. This uncertainty and volatility in crude pricing is definitely impacting the base oil industry.

Setting the Pace

In a rapidly declining price environment, tumbling upstream prices for crude oil and vacuum gas oil are setting the pace for base oil prices in 2015, after base oil prices had fallen across the globe during 2014. Lower crude prices impact base oil refiners on different levels.

In part, it poses some challenges as refiners may be forced to discount base oils that were produced using feedstocks contracted for when prices were higher. End users are well aware of falling feedstock prices and the generally weak market conditions, and they expect some price relief.

Also, historically, low crude prices entail low base oil margins in absolute terms. On the positive side, base oil producers profit from lower crude prices as the cost of capital on their inventories goes down.

During 2014, the crude-price-driven decline of base oil prices has been exacerbated by the oversupply in the global base oil markets. Three million tons per year of capacity has been added to the market at a time when demand growth was very weak.

Indeed, lubricant demand in 2014 registered only very modest growth, reflecting a year of global economic struggle. Although the Eurozone Composite Purchasing Managers Index averaged 52.7 for 2014 and has signaled expansion for 18 straight months, expansion has been slow and recession was avoided by only a narrow margin.

Purchasing Managers Indexes are economic indicators derived from monthly surveys of private sector companies. The two principal producers of PMIs are Markit Group, which conducts PMIs for over 30 countries worldwide, and the Institute for Supply Management, which conducts PMIs for the U.S.

Throughout 2014, Gross Domestic Product grew by 0.9 percent in Europe as a whole and by 1.4 percent in the 28 European Union countries. In the United States, annual GDP growth rate was 2.4 percent.

The most significant impact on lubricant demand growing less than expected resulted from slowing growth in emerging markets. The HSBC Emerging Markets Index, a weighted composite indicator derived from PMI reports in 17 emerging economies, averaged 51.4 over 2014, the lowest for a calendar year since the series started in 2005. In particular, Chinas GDP growth in 2014 reached 7.4 percent. This marks the countrys weakest expansion in 24 years.

2015 & 2016 Outlook

The January update of the World Economic Outlook projects global growth in 2015 and 2016 to be 3.5 percent and 3.7 percent, which represent downward revisions of 0.3 percent relative to the October 2014 release. The revisions reflect a reassessment of prospects in China, Russia, the Euro area and Japan as well as weaker activity by some major oil exporters because of the sharp drop in oil prices.

The U.S. is the only major economy for which growth projections have been raised and assessed to 3.6 percent. Growth in the Euro area is forecast to be much more modest, and GDP is expected to grow by 1.2 percent in 2015 and 1.4 percent in 2016.

In emerging markets and developing economies, growth is projected to remain broadly stable at 4.3 percent in 2015 and to increase to 4.7 percent in 2016. This represents a weaker pace than forecast in October.

What is driving the downturn in the emerging markets? Three main factors explain the downshift.

Lower growth in China and its implications for emerging Asia: Investment growth in China declined in the third quarter of 2014, and leading indicators point to a further slowdown. Slower growth in China will have important regional effects, which partly explains the downward revisions for growth in much of emerging Asia. In India, the growth forecast is broadly unchanged, however, as weaker external demand is offset by the boost to the terms of trade from lower oil prices and increased industrial and investment activity after policy reforms.

Much weaker outlook in Russia: The projection reflects the economic impact of sharply lower oil prices and increased geopolitical tensions, both through direct effects and loss of confidence. Russias sharp slowdown and ruble depreciation have also severely weakened the outlook for other economies in the Commonwealth of Independent States. Russias GDP is expected to decline by 3 percent in 2015 and 1 percent in 2016. Elsewhere in the CIS, GDP is expected to grow by 2.4 percent in 2015 and 4.4 percent in 2016.

Downward revisions to potential growth for commodity exporters: For many emerging and developing commodity exporters, the projected rebound in growth is weaker or delayed compared with October 2014 projections. This is due to the impact of lower oil and other commodity prices on the terms of trade. As a result, lower real incomes are now projected to take a heavier toll on medium-term growth.

Some oil exporters, notably members of the Cooperation Council for the Arab States of the Gulf, are expected to use fiscal buffers to avoid steep government spending cuts in 2015. However, the room is limited for monetary or fiscal policy responses to shore up activity in many other exporters. Lower oil and commodity prices also explain the weaker growth forecast for sub-Saharan Africa, including a more subdued outlook for Nigeria and South Africa.

Chinas GDP growth is estimated at 6.8 percent in 2015 and 6.3 percent in 2016.

Impact on the Lubricant Industry

Because lubricant demand closely tracks GDP growth at the regional level, 2015 will most likely be a year of growth for the lubricant market, albeit at a modest pace, probably only marginally higher than in 2014. However, in the coming two years, 3.8 million tons per year of new API Group II and III capacity will come on stream. This means that the near term will continue to see an oversupplied market struggling to rebalance, increasing pressure on Group I refiners, especially in Europe, and possibly triggering further production rationalization.

The real crunch will come if oil prices begin to recover because base oil producers will feel strong margin pressure, with Group I producers likely to feel the most pain. In addition, continued low oil prices will most probably accelerate the conversion to Group II and III system base oils, further eroding the market share of Group I base oils.

As of late February, three refiners have announced that they will convert their Group I production in Europe during 2015, and a total of 800,000 t/y of Group I capacity will disappear. Another refiner is in negotiations with its unions to close down, completely or partially, its Group I production. A fourth plant is for sale and will be converted into a terminal in the absence of a buyer, placing another 700,000 tons of Group I capacity at risk.

These production cuts will prove insufficient since the new capacity coming on stream largely exceeds the planned closures and will add to an already oversupplied market. Added to modest prospects for demand growth in the mid-term, further production rationalization or reassessment of planned expansion projects are to be expected.

Valentina Serra-Holm is Marketing Director for Nynas AB, based in Stockholm, Sweden. She can be contacted at valentina.serra-holm@nynas.com.