Oil – A New Hope or The Empire Strikes Back?

Published at Feb 26, 2016, in Features

After more than a year of doom and gloom surrounding oil there may be a flickering light at the end of the tunnel – but it’s probably not going to be as great as everybody thinks it is.

The current oil crisis comes down to one simple thing: oversupply.

Thanks to the advent of shale drilling on a wider scale in the US to produce oil, the US has had to import less crude than it had been doing previously.

Termed the ‘shale gale’, it prompted talk of the US becoming energy self-sufficient – much to the chagrin of oil producers in other markets.

After all, if the US stops buying oil from the world market, it basically means that the oil which would have been destined for the US finds a way to another market.

This is essentially what happened, with US production meaning there was more oil in the system than previously experienced.

The rational response, one would assume, would be to choke back production to stop the oversupply dragging down prices.

Except, that didn’t happen.

OPEC, which controls roughly 60% of the world’s crude exports decided in its wisdom to keep pumping at current and projected levels.

But why would it do that?

Led by powerful nations such as Saudi Arabia, OPEC’s theory was that if it drove the oil price lower it would send US drillers out of business and effectively kill off US production – which had seen price pressure in the first place.

It made a perverse kind of sense, but as time goes on OPEC has realised that it may just be harder to kill off US producers than first thought.

Analysis from Bloomberg’s business intelligence unit in January found that there were quite a number of plays in the US which could happily break even if oil approached $30 per barrel.

Break-even prices for several plays in the US. Courtesy Bloomberg Business Intelligence

There also happens to be a lot more oil in storage than previously thought, which means OPEC may be re-thinking its strategy.

Earlier in the year, it emerged that Russia and Saudi Arabia were meeting to discuss whether or not to cut back production – essentially admitting defeat to the frackers in the US.

It has since emerged that Venezuela and Qatar will be added to those talks when the four meet next month.

Venezuela in particular has been hit hard by the current oil crash, with much of its economy geared to crude exports.

But, and this is the sticking point, the meeting is expected to be about a freeze in the rate of production rather than a wholesale cut – which had been the hope of the market.

The Saudi Arabian oil minister Ali Ibrahim Al-Naimi said this himself. You’d figure he’d have idea of the way the parties are thinking.

While a freeze in the rate of production is nice, it’s hardly going to captivate the market or oil traders in the short-to-medium term the way an immediate production cut would.

So why the conservatism?

Iran.

The lifting of US-led sanctions against Iran earlier this year has changed the game for OPEC. Iran, one of the OPEC members, had been restricted in who it could sell its multitude of oil to for years.

However, when the US government lifted the sanctions in response to cooperation over Iran’s nuclear energy program it meant Iran was now free to play the market and sell to whomever it chose to do so.

While stats are fast and loose at this stage, the signs are there that Iran is keen to jump back into the market and get its economy going again.

After all, it’s just bought 118 jet planes from France to replace its dated fleet – a deal valued at a cool $25 billion.

Can you imagine telling Iran that it won’t be able to take full advantage of its new-found freedom in the oil market because OPEC is cutting back production?

It would be political bedlam.

Instead, a freeze in production increases may be more palatable while offering a road back to an oil price environment which suits both OPEC and the US.

That’s why hopes of an immediate cessation to the trade war against OPEC and the US is perhaps a touch hopeful.

Instead, an oil price increase is likely to play out over a longer term.

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