By David Yager | –
As the September 26 to 28 “informal” meeting of OPEC producers in Algeria draws near, media speculation could easily cause mental anguish. On oil news websites simultaneous headlines claim OPEC will both fail and succeed in capping output. Called by OPEC August 8, the stated purpose of the gathering was, “OPEC continues to monitor developments closely, and is in constant deliberations with all member states on ways and means to help restore stability to the oil market”.
Obviously that is the view of the organization, not the member countries. Iran and Saudi Arabia remain at loggerheads over which will exert the most influence in the Persian Gulf. Iraq, Nigeria, Libya and Venezuela are all experiencing various forms of internal meltdown which thankfully (human suffering notwithstanding) is keeping a lot of oil off the market.
On September 20, OPEC Secretary-General Mohammed Barkindo was talking publicly about a one-year production freeze among OPEC members and Russia. Two days later it was reported the Saudis would cut output if Iran followed. We’ll see. In August, OPEC believed non-OPEC production would fall by 1 million b/d this year from 2015 and a bit more in 2017. Even the most pessimistic estimates for demand growth see 1.2 million b/d this year and next. But there is no consensus on these numbers.
At some point global supply/demand curves will cross enough to cause prices to rise. Some data indicates they already have. With low oil prices causing massive cutbacks in spending on new supplies, everyone agrees oil prices are very unlikely to revisit recent record lows and will rise over time. The question is how much and when. The rest of this article is dedicated to the thesis that the market and the price are not the same thing so nobody actually knows. Despite relentless bad news this means something good could easily occur.
On September 14, Goldman Sachs Group Inc. analyst Jeff Currie opined there would be no price rally anytime soon. In a Bloomberg article Currie is quoted as saying the risk is “to the downside” in the absence of any major drivers to make prices rise. The result is that for the next year WTI will be stuck in the US$45 to US$50 range. Curry said, “It really looks similar to the period of the early 1990s, when we were at US$20 oil. Is US$45 to US$50 the new US$20? I am not ready to say we are in this new equilibrium environment, but it sure does feel that we’re moving in that direction”.
As happens every day when any news one way or another is released, oil markets responded and WTI moved. In this case it fell. Crude has been generally down for the past two weeks since WTI reached a recent high of US$47.83 on September 8, although it recovered somewhat on September 21 and 22 on U.S. inventory declines.
The problem with the Goldman prognosis is oil markets today look nothing like they did in the early 1990s. Then oil was half-way through an extended period of low prices from 1985 to 2004. It is quite common to say oil markets are similar to what they were 20 and even 30 years ago. Except it’s wrong. Review the following and reach your own conclusion.
In 1986 the average OPEC price was only $US13.53, 40 percent of recent peaks. This is sort of like today. But note the market overhang in 1985. Using today’s price drivers oil would have negative value. While the Iran/Iraq war from 1980 to 1988 pulled a lot of oil off the market, note that to hold the price above US$27 in the first five years of the 1980s Saudi Arabia shut in 7 million b/d. Now that’s a swing producer! OPEC would not see the 1985 average price for 18 years. Whatever the Saudis may or not be doing today, they only have a tiny fraction of this excess capacity now, if any.
The cause of this oil price collapse was a massive surge in non-OPEC production, the result of record high oil prices (10X increase over 10 years) and the determination of the rest of the world not be held hostage by OPEC.
The first Gulf War in 1991 resulted in chaos in Iraq and the oil fires of Kuwait. But this seemed to have no measurable impact on total OPEC output which rose annually thereafter. Total non-OPEC production in 1973, when OPEC started flexing its muscles, was only 19.8 million b/d. Twenty years later it was 30.9 million b/d, over 50 percent higher. The rest of the world effectively squeezed OPEC out of the market causing a price collapse that lasted for nearly 20 years.
An extended period of low oil prices created the market conditions for 10 years of much higher oil prices from 2004 to 2014. One was continued growth in demand and the other was a flattening of non-OPEC production growth. In 2006 a research report from the Oxford Institute for Energy Studies revealed global spare production capacity which had peaked at an estimated 10 million b/d in 1985 had shrunk to almost zero by 2004. In 2000 OPEC output was back above 30 million b/d for the first time since 1979, 21 long years later.
Which is why today’s world oil markets look a lot more like 2004 than 1994. According to OPEC’s monthly World Oil Supply report total output for August was 33.2 million b/d, a record. This is up over 2 million b/d from 2014 with the major contributors being Iran (1 million b/d), Iraq (1.1 million b/d) and Saudi Arabia (1 million b/d) offset by declines in Venezuela, Algeria, Libya and Nigeria.
Since OPEC has had no quota for nearly two years and the stated game has been volume, not price, one can safely assume OPEC’s current spare capacity is effectively zero. While an unlikely outbreak of peace and tranquility in one or more troubled OPEC member countries could put more oil the market, because of the nations involved it is extremely unlikely all members will ever produce at full capacity at the same time. It has rarely happened before. Reports indicate Nigeria and Libya will resume some half million barrels per day of exports. But in a world soon to consume 95 million b/d this amount means much more to speculators than consumers.
Goldman Sachs is not alone in predicting “lower for longer”. This is what almost everybody says. On September 20 the Financial Post reported RBC Capital Markets was of the view oil prices would indeed rise but not until 2019. RBC says 2.2 million b/d of new non-OPEC production will enter the markets this year, 1.3 million b/d next year and 1.6 million b/d in 2018. Somehow U.S. production will rise by 900,000 b/d from 2017 and 2019 despite falling by 1.1 million b/d in the past 15 months and with rigs count at historic lows. At the same time RBC reported the 124 E&P companies it follows will cut spending another 32 percent in 2016 from 2015, a $US106 billion reduction.
However, not everybody is saying what you see is what you get. On September 14 the Financial Post carried an article from The Telegraph and ran it under the title, “When oil turns it will be with such lightning speed that it could upend the market again”. Citing the lowest levels of oil discoveries since 1952, annual investment in new supplies down 42 percent in the past two years and how the International Energy Agency (IEA) estimates 9 percent average annual global reservoir depletion, the article stated, “…the global economy is becoming dangerously reliant on crude supply from political hotspots”. “Drillers are not finding enough oil to replace these (depletion) barrels, preparing the ground for an oil price spike and raising serious questions about energy security”.
Depletion of 9 percent per year is about 8.6 million b/d. Add demand growth and you’re approaching 10 million b/d. How do the crystal ball polishers of the world who see flat oil prices for the foreseeable future figure producers can replace this output when others report $US1 trillion in capital projects have been cancelled or delayed over the rest of the decade?
The last ingredient in the oil price confusion in inventory levels. OECD countries currently hold 3.1 billion barrels of oil inventory. That sounds like lot. But what nobody reports is the five-year average is about 2.7 billion barrels. Refinery storage tanks. Pipelines. Field locations. Tankers in transit. It’s huge. The current overhang is about 6 days of production higher than it has been for years, about 60 days. So inventories are up roughly 10 percent from where they have been.
Obviously this is going to take a change in the global supply/demand balance to return to historic levels and will dampen prices until it does. But don’t believe OECD inventories must go to zero. With no oil in storage for tomorrow’s massive supply chain, crude would fetch $1,000+ or more and the world’s economy would collapse.
What we do know is the global oil data avalanche is relentless and each and every one causes oil prices to wiggle. That’s because making money trading is, at least volumetrically, a much bigger business than finding and producing the product. The Chicago Mercantile Exchange (CME) brags, “Trade Light Sweet Crude Oil (WTI), the world’s most actively traded energy product”. And trade they do. On February 10, 2016 the CME alone (other exchanges also trade WTI) traded a record 1,609,771 WTI contracts of 1,000 barrels each. That day 1.6 billion “dry barrels” were traded while actual North America production, which is priced off WTI, was less than 13 million “wet barrels” of actual oil. This means on that day 123 “futures market” barrels were traded for every barrel produced. On just the CME.
This assures financially engineered volatility. It’s gotta move or this new industry has nothing to do. Markets are now conditioned to scheduled weekly data releases of U.S. inventories and rig counts, all of which cause prices to change. Which is of course good for traders. This leads to speculation leading up to releases, voluminous reporting and analysis thereafter, and an oil price vacillation one way or the other almost immediately as traders shift their bets based on the latest snippets of data.
The weekly reports from the U.S. Commodity Future Trading Commission, where traders disclose their activity, show the wagers are both long and short. That’s what hedge funds do. But even a change in the number of futures on either side of the trade is now newsworthy as to whether the dry barrel speculators think oil will go up or down. This is called “market sentiment”, something entirely different than actual oil market performance.
That futures trading was invented so producers could lock in a stable future cash flow is long forgotten. After all, they only hedge the wet barrels they believe they will produce, a tiny fraction of the activity in modern commodities.
The current production overhang suppressing markets is only about 1 million b/d or less depending upon which forecast you’re looking at. Both the IEA (Paris) and the EIA (Washington) see the curves very close if they haven’t crossed already. Neither agency sees any overhang by the end of the next year. That’s why today’s macro-oil markets bear no resemblance to those of decades past. And the biggest change today, which is rarely mentioned, is unprecedented levels of trading and speculation. “That’s the market”, everyone accepts without question. But is it really?
Exploration and production companies must replace reserves and sustain production to stay in business and increase output to grow. Yet there is great anguish over price every time they succeed. The reward for raising output is to reduce the price. Is this actually a real business?
Lost in the oil prices trees is the global market forest. OPEC has no meaningful excess capacity. Non-OPEC production is flat out and, in the face of massive spending cuts, is more likely to fall than rise because production increases will be more than offset by natural reservoir depletion. Demand will continue to increase despite the well-publicized claims by the anti-carbon crowd that oil is dangerous and has no future. Commodity traders only care about what will happen to prices in the next 10 minutes or 10 months, not the next 10 years. This creates price volatility which forces everybody in the business for the long haul – producers, service providers, equity investors and lenders – to make the wrong decisions.
In Q2 2008, when WTI broke US$140, there were allegations by Middle East producers that the price was driven that high by speculators. Thanks to the economic meltdown, WTI would be US$30.28 by Christmas that year, 80 percent lower. Neither supply nor demand had changed enough to justify a price swing this massive. After the collapse began in late 2014 the same countries claimed the same thing. In February this year, WTI fetched only 25 percent of its value in June 2014.
The textbook definition of free markets, religiously recited by defenders, is that at some point commodity prices should reflect replacement cost. In reality this is a number the posted oil price only passes through one direction or the other every few years. Today a 95 million b/d market trades on the tiniest marginal barrels that often don’t even exist yet. Like when WTI drops because three more rigs drilling in West Texas may add 1,500 b/d of production in two months.
Oil prices must and will go up. Okay, when? In reading everything about this subject for years, the number one driver of oil prices nowadays is not all the numbers we are bombarded with but the sentiment of traders. Today oil will rise only when futures traders figure they will make more money going long than short. This hasn’t happened yet but the fundamentals ensure it will. And when it does, the speculators will pile in and WTI will blow through US$60 quickly and likely not slow down thereafter. This will set the stage for another massive ramp up ensuring yet another crash. Because volatility is not only assured but required.
Based in Calgary, David Yager is a former oilfield services executive and the principal of Yager Management Ltd., an oilfield services management consultancy. He has been writing about the upstream oil and gas industry and energy policy and issues since 1979.