So Much for That Oil Rally

Pundits and oil analysts had started to breathe a little sigh of relief as the per barrel price of oil had begun to act the way it was “supposed” to. Each week saw the price creeping back up to respectable levels and oil producers began to think that gloom and doom would fade in the wake of $50 to $60-dollar oil.

The OPEC system is not really functioning anymore—not like it has in the past, but it seemed to be working better than it has been lately, as the producers were seemingly in agreement that something had to be done about the oversupply of crude. Only a few days ago, it seemed certain the major oil states were going to agree to limit their output or at least freeze it where it is right now. That seemed a pretty logical move given that oil prices are still sitting at record lows. There is no sense that demand was going to start to rise anytime soon—not as long as the prognosis for the global economy remains weak.

That was the thinking before the end of the weekend and the failure of the OPEC states and Russia to reach a deal as far as output is concerned. The idea was that the heavyweights in the oil sector (excluding the U.S., Canada, Britain and Norway) would agree to freeze output at the current level. This was an idea floated by Russia and Saudi Arabia at the start of the year, and the two have been trying to get the other OPEC members to go along with the idea ever since. In the end, the Saudi government elected to bail on this agreement, as it is not willing to freeze output unless the Iranians are on board with that plan. To say that Iran has little incentive to play along is an understatement.

Iran is just starting to see sanctions lift and just starting to get back to the oil production levels it sported prior to the imposition of these restrictions. To freeze at current output levels would mean voluntarily undoing all the gains it could be making as these sanctions are removed. To note that there is no love lost between Iran and Saudi Arabia would be another understatement as these states are exceedingly hostile to one another. There is no desire to do much of anything to assist one another—even if that would be good news for both.

The global oil markets reacted to the news swiftly as the per barrel price fell by 5% and has been continuing to fall since. If there is no unified decision to reduce output, the glut will live on, and the only thing that will wrench oil prices back up will be an increase in demand sufficient to dry up that supply. Nobody sees that happening any time in the near future. Iran is committed to ramping its production up to around 4 million bpd; that is up from the 2.3 million bpd it produced last year. There is not enough demand for the oil that has been supplied already, and an additional 2 million barrels on the market will not make things any easier. The expectation of an oil sector gain has been dashed before it really started.

The thinking now is that oil prices will stop their recovery, and hopes of $60 a barrel oil by the end of the year have been dashed. The expectation has shifted to prices closer to $40 unless there really is a major surge in demand in the U.S. during the summer driving season. The problem is that it is not the U.S. that is behind in the consumption of oil—it is the rest of the world and especially the Europeans. The oil analysts had been expecting a more normal oil situation by 2017 and now there is real doubt. At this point, there are more limited scenarios as far as the price recovery of oil is concerned.

The first, and presumably the easiest, means by which the price of oil can go up is for the oil states to agree on that freeze. At the moment, two states hold the key to some kind of agreement—Saudi Arabia and Iran. They both have good reasons for their stance, and it will come down to whether they can set aside their differences and mutual enmity. It is actually far easier for Iran to do business with the “great Satan” than to work with the Saudi Oil Ministry. The feeling of hostility is mutual; there is therefore little flexibility as far as the Saudi position is concerned. To break the logjam, the Iranians will have to be allowed to produce more but perhaps not as much as they would like. The additional one or two million barrels from Iran would mean that other states would have to reduce their output accordingly and that will not be a popular position for the countries that would have to shoulder the bulk of that reduction—Saudi Arabia and Russia.

The second means by which the oil glut is resolved would be demand driven. There would have to be enough additional demand to soak up the current supply and handle more coming from the likes of Iran. That means getting the U.S. all the way back to consumption levels that are reminiscent of the last decade. It also means the rest of the world has to pick up the pace. That sounds feasible but not as long as global growth continues to sag and limp along at just around 3%, as opposed to the almost 6% that marked activity prior to the recession. There is no switch to flip as far as spurring consumption is concerned.

There is a third option. That involves the elimination of some of the oil production competitors. This was always the threat that Saudi Arabia imposed back in the strong OPEC days. If a country elected to consistently refuse the Saudi/OPEC imposed quota, the states that could produce oil cheaply would simply flood the market and drive prices down to the point that other states would no longer be able to produce. This is what Saudi Arabia tried to do in 2014 to force the U.S. shale oil developers to back off. That failed because the U.S. is a far more determined producer (as is Canada). There is far too much sunk investment in the U.S. and Canadian oil patch to walk away from. There are, however, states that are far less resilient, and they could be forced out. It is likely that five current producers could be forced out if prices stay below $40. These include Venezuela, Algeria, Angola and Ecuador and perhaps even Nigeria. Even a partial withdrawal from the oil world on the part of these states could pull enough oil off the market to end the glut. The problem is that this reduction will certainly not be voluntary, and it will hardly be organized or even close to permanent as these are all states that rely on oil for over 90% of their budget.

- Chris Kuehl, Ph.D., NACM economist and co-founder of Armada Corporate Intelligence

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