23 April 2018
Oil prices reported from trading on open exchanges in a worldwide fungible market vary over a range of approximately 10% largely based on exchange traders’ perceptions of the importance of “builds” and “draws” of oil storage. Storage data are micro-analyzed with respect to amount and timing. Storage in Cushing, Oklahoma, the basis of trading contracts on the NYMEX has an outsized influence but is only about one-half of one percent of the world’s storage and is determined as a small difference of two large numbers, each of which is inaccurate and corrected a few months later. Nevertheless, these bad data are combined with conjecture, fantasies, and rumors regarding value of the dollar, bombings in the Middle East, driving habits of millennials, electric car sales, ice sheet melting, Kim’s missile tests, Chinese teapot refining volumes, Palestinian riots, Saudis letting women drive, Comey’s memos on phony dossiers, and Russian birth rates to fine-tune oil trade pricing decisions.
The oil industry itself is more influenced by long-term trends, however. Periodically, political and economic trends converge with technological developments to cause fundamental transitions in the industry, its business relationships, oil markets, and oil prices. Such profound convergences and transitions happened at the turn of the 20th century, in the early 1930s, in the 1970s associated with the Arab Oil Embargo and other perceived political disruptions, and late in the first decade of the current century.
Around 2005 to 2006, world oil demand reached the world oil industry=s production capacity for the first time in history putting upward pressure on oil prices. At about the same time, technological improvements in hydraulic fracturing and horizontal drilling, which were used successfully to develop the Barnett Shale gas field in Texas, were adapted to develop Bakken oil resources in North Dakota.
Following the financial crisis of 2008-9, the Federal Reserve injected liquidity into the US banking system (a program known as Quantitative Easing, QE, a term worthy of SNL) and maintained low interest rates. The US Congress passed a bill, known as Dodd-Frank, to cripple banks and restrict their activities. Under these conditions, an acceptable investment was oil drilling. Access to low-cost capital, increasing oil prices, and effective development technologies for low-permeability oil reservoirs combined to stimulate independent US oil companies to develop resources which had been previously uneconomical. An oil boom followed. US production increased by about 4 2 million barrels per day; a disruptive event which surprised many parts of the industry and quite a few governments – including our own.
In August 2014, the Federal Reserve ended QE and triggered an oil price drop from the $100-$110 range. In late November, as oil prices reached the mid-70s, Saudi Arabia, perceiving a threat to its market share by increasing US production, announced it would not cut back its production rate to maintain oil prices. Evidently the Saudis believed they could survive a period of low prices better than American Ashale drillers@ and thus maintain their market share and stop further American production increases for the cost of a short-term revenue decrease.
In the event, oil prices continued to drop well into 2015. US production increased until mid-2015 because of hedges and the wonders of Chapter 11; it did not start to decrease until mid-2015, one year after the initial price drop. With US production increases, world production capacity exceeded world demand. By late 2015, this excess capacity was generally estimated at about 1.5% – which the press immediately labeled a “Glut”. After about two years of reduced revenues, the Saudis decided US drillers would not quit so they organized a production cut by OPEC members and drafted Russia and other non-OPEC members to join them. This group, known as OPEC+, agreed to cut oil production by slightly more than the “Glut”; 1.8 million bbls/day, to support prices. Compliance with the oil cut was surprisingly high; oil prices increased by about 65% to the $65 to $70/bbl range for a 1.8% production cut. Even dictators and despots can understand the benefits of that – especially with the Russians involved.
Several trends are converging again – partly in response to these events, general economic trends, volatility and unpredictability of oil prices, and perpetual turmoil in the Middle East.
- Capital budgets were reduced significantly after the oil price drop in 2014-15 for all non-Atight@ oil or gas development. Worldwide, many large projects were postponed; after re-activation, these projects typically will need 4 to 6 years to reach full production. Non-US oil production capacity is declining, not increasing, and OPEC+ has constrained production about 1.8 million bbls/day. US oil production is increasing nearly one million bbls/day each year. World demand is increasing about 1.5 million bbls/day each year.
Various storage reports now show storage volumes approaching the five-year average storage volume which was the original objective of the OPEC+ group production constraints. The press is now touting The End of The Glut. Of course, the five-year average storage now includes about 3 ½ years of increased storage since the beginning of The Glut – but never mind.
With these trends, demand will reach world production capacity in late 2020 – 2021. As oil shortages develop with marginal pricing in open markets prices will increase rapidly over the next 2-4 years.
- With a worldwide fungible oil market, supply and demand in near balance, and prices determined by open bidding for marginal barrels, small variations from oversupply to shortage cause extreme price volatility. Volatility of the price of oil, the largest commodity in international trade and a vital component of a modern economy, is undesirable to investors, oil companies, governments, industrial and commercial users, and consumers; everybody but traders.
New marketing and price determination relationships and procedures will evolve to establish long-term price stability. Several large international industry traders are already in discussions to establish such relationships. Saudi Arabia and Russia are discussing long-term (ten- to twenty-year) cooperation to adjust production rates to market demand for price stability. (This was a practice followed in the US, led by the Railroad Commission of Texas, for forty years from the early 1930s to the early 1970s). As these relationships mature for ever-increasing amounts of production, volatility will increase for non-participants. It behooves one to establish such relationships soon.
- The Middle East shows no signs of becoming stable and peaceful. The US is becoming frustrated and weary trying to help it become so with nothing to show for its efforts and costs. Hallucinations about a Middle East populated by Jeffersonian democrats finally have faded. The US needs to re-direct its foreign policy, diplomatic, intelligence, and military efforts to other parts of the world and other concerns. The US currently is in a strong position to work with neighboring countries and take oil out of the equation of its Middle East considerations.
The oil industry is entering a period of structural transition with the convergence of these trends. It is an opportune time to initiate or expand investment in the industry and establish positions and relationships to take advantage of the coming changes. One can also hope that Mr. Trump’s recent tweeted perception about oil prices “artificially too high” and oil “all over the place” is soon corrected and does not become the basis of policy. It is a time for the US Government to analyze conditions accurately and to make policy on a clear understanding of current trends; it has a record of bad policy-making from lack of understanding.