Oil price fluctuations more likely than a rise
On May 25th, OPEC is holding a ministerial conference to decide whether to extend its oil production cut agreement in another − more or less successful − attempt to manage oil prices, which will likely lead to more price volatility and more confusion in the market. Saudi Arabia, playing a lead role in the accord, may find a steadfast ally in Russia − the two countries together account for 22% of global output. With the other five OPEC members from the Persian Golf, namely Kuwait, Qatar, UAE, Iraq and Iran, which is already allied with Russia, their share in production is 36%.
The OPEC deal was brokered in order to push up prices above USD 50 per barrel and keep them in that range. Accordingly, the parties to the agreement (all OPEC members except Libya and Nigeria and a few non-OPEC countries, mostly Russia) vowed to reduce their total production in the first half of 2017 by nearly 1.8 mbd (million barrels per day) from October 2016 levels. Despite surprisingly consistent compliance with the accord, the price target was only achieved for the first two months of 2017, when the market was so excited about the production cuts that it disregarded the symptoms of weakening oil market fundamentals and paid little attention to extreme futures positioning or to historically low price volatility. When finally digested, all that information triggered a price correction to about USD 50 per barrel, with downward trends continuing as more new data came in.
Is the agreement working? A large part of the market believes that it is, but has not yet come to full fruition and must be extended until the end of this year to produce the desired outcome. On May 15th, the Energy Ministers of Saudi Arabia and Russia said in a joint statement that their countries were ready to extend the deal until March 2018, stoking the market’s expectations and causing oil prices to rebound to the target levels. In a report released a couple of days ago, the International Energy Agency also expressed an opinion that market re-balancing was continuing, but OPEC’s role in the process was not over yet. Many others, however, believe that market interventions by OPEC are a futile exercise as they spark a reactive surge in American “instant” oil output, and consequently their objective (oil prices settling above USD 50 per barrel) cannot be met.
The effectiveness of OPEC’s production cuts is a moot question in the light of what has been going on in the oil market since the cuts were announced and began to be phased in. First of all, prices react to changes in the global supply and demand in line with information that is incomplete and reaches market participants with a long delay. Changes in the supply and demand of crude oil and fuels are most easily traceable in OECD countries, which report relevant data to the International Energy Agency. Knowing the current stock, production and demand trends in OECD countries from such regular reports, market participants extrapolate them to the global market. On the other hand, information on supply and demand trends in the OPEC countries and Russia reaches the market with a considerable delay and is less reliable, because it must be inferred from other data, e.g. the number and schedule of loading and unloading operations of oil tankers. In the case of those countries, it is difficult, for instance, to ascertain what happens to crude oil that does not leave a country − whether it is consumed or stockpiled − which is of crucial importance for assessing how effective production cuts have really been.
An immediate cause of an oil price fall is information on commercial stocks of petroleum and liquid fuels in OECD countries (a visible part of global stocks). In Q1 2017, they rose by 0.3 mbd, confounding expectations. There can be little doubt that the rise was due to an increase in US oil production, which had been seriously underestimated. Another, less known, factor which contributed to the growth of commercial stocks in OECD countries was a stock draw in OPEC countries. It turns out that, although the OPEC countries did cut their production levels, they also increased their exports of previously stockpiled crude oil and liquid fuels in order to take advantage of the rising prices. The exports flowed to European (including Polish) refineries, replacing Brent and URALS, and to US refineries, successfully competing against American crude. Glutted with imported oil, neither Europe nor the US saw much stock draws.
So what lies ahead? On the one hand, we already know that US shale oil production is soaring. In early 2017, the expected increase was estimated at 0.4 mbd, while the latest estimates are closer to 1.0 mbd. This is attributable to several factors, with only the key ones mentioned here. The break-even point for shale oil production is now estimated to have gone down to USD 40 per barrel. Efficiency of that production has also improved quite incredibly. According to the latest assessment, you only need 15,000 wells to produce 1.0 mbd from shale formations, while a few years back, in 2014, you still needed as many as 40,000 wells to ensure the same production levels. What is more, shale oil exploration and production companies took advantage of the oil price rise in late 2016 / early 2017, hedging their profits over a two-year time horizon with oil futures/forwards entered into at prices above USD 50 per barrel. As a result of those transactions, the US E&P sector is no longer facing any shortages of capital, due to oil price fluctuations, with which to finance their exploration and production work. On the other hand, little is known of the size of crude oil and fuel stocks in OPEC countries and Russia, making it difficult to assess their potential impact on the global supply-demand balance in the coming months. Stock draws have allowed OPEC to increase oil sales despite production cuts. Maritime traffic data seems to suggest that the source was tapped into as early as December. The biggest surge in commercial inventories was reported by OECD countries in January, when the oil tankers reached their destinations in Europe and the US. In February and March, OECD commercial inventories began to shrink, which indicates that OPEC countries might have by then managed to sell out excessive stocks.
Global stocks probably decreased in the first quarter of 2017, too. Therefore, the production cuts are bearing fruit and their extension may bring about a rise in oil prices, which is especially counted on by Saudi Arabia, preparing an IPO of the state-owned Saudi Aramco and awaiting its valuation. The parties to the output agreement can already view current estimates of crude oil production in the US, Canada (where production is on the rise, too) and other non-OPEC countries, and have data on the global commercial oil stocks overhang (they know their own and OECD’s inventories, the latter being in the region of 0.5 mbd). Juxtaposed with the global demand growth forecasts (1.6–1.7 mbd in 2017 and approximately 1.5–1.6 mbd in 2018), this data allows them to estimate the level of production cuts necessary to bring OPEC stocks back to the five-year average. If stocks begin to clearly trend that way, oil prices should climb above USD 50 per barrel.
Judging from initial declarations, the OPEC countries and Russia will have to put in much more effort to attain their targets this time than they did after the first deal. It must also be borne in mind that the more effective output cuts, the higher the resulting oil price rise and the stronger the reaction from shale oil producers, which increase supply, in turn suppressing the price. Saudi Arabia does not, however, want to see oil prices soar above USD 60 per barrel, because it believes that US producers would find such level profitable enough to excessively step up their output. As has already been mentioned, the break-even point has probably plunged to USD 40 per barrel, which is a major risk factor in price management. Keeping oil prices above USD 50 per barrel in the long run may prove very challenging, and if production cuts are discontinued, 2018 is likely to see surplus supply, commercial stocks growth, and falling prices. In short, the planned market intervention may be doomed to repeat the past, when faith in the OPEC-cast production anchor and oil prices kept too high above the marginal cost of production led to a price collapse.
Today, there is also a lot of evidence suggesting that with oil prices above USD 50 per barrel, US and Canadian production capacity will be enough to fill the supply gap forecast to materialise in 2019 and beyond as a result of many conventional production projects being discontinued. If this is the case, over the next five years we will not see oil prices trending upwards but fluctuating within a rather broad range of USD 40–65 per barrel, as has been suggested e.g. by Edward Morse. Therefore, our strategy assuming the oil price at USD 55 per barrel in 2017–2018 fits in with that scenario.