Saudi Arabia’s ‘Vision 2030’ is looking a lot less clear

Saudi Arabia’s U-turn to revive oil output quotas is not working and fails to address the changing future of oil demand, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog

Saudi Arabia’s move into recession comes at an unfortunate time for its new Crown Prince, Mohammed bin Salman (known to all as MbS).

Unemployment is continuing to rise, threatening the social contract. In foreign affairs, the war in Yemen and the dispute with Qatar appear to be in stalemate. And then there is the vexed issue of King Salman’s ill health, and the question of who succeeds him.

This was probably not the situation that the then Deputy Crown Prince envisaged 18 months ago when he launched his ambitious “Vision 2030” programme and set out his hopes for a Saudi Arabia that was no longer dependent on oil revenues. “Within 20 years, we will be an economy that doesn’t depend mainly on oil . . . We don’t care about oil prices — $30 or $70, they are all the same to us. This battle is not my battle.”

The problems began a few months later after he abruptly reversed course and overturned former oil minister Ali al-Naimi’s market share policy by signing up to repeat the failed Opec quota policy of the early 1980s.

His hope was that by including Russia, the new deal would “rebalance” oil markets and establish a $50 a barrel floor under prices. In turn, this would boost the prospects for his proposed flotation of a 5 per cent stake in Saudi Aramco, with its world record target valuation of $2tn.


But, as the chart above shows, the volte face also handed a second life to US shale producers, particularly in the Permian basin, which has the potential to become the world’s largest oilfield. Its development had been effectively curtailed by Mr Naimi’s policy.

The number of high-performing horizontal drilling rigs had peaked at 353 in December 2014. By May 2016, the figure had collapsed to just 116. But since then, the rig count has trebled and is close to a new peak, at 336, according to the Baker Hughes Rig Count.

Even worse from the Saudi perspective is that oil production per Permian rig has continued to rise from December 2014’s level of 219 barrels a day. Volume has nearly trebled to 572 b/d, while the number of DUC (drilled but uncompleted) wells has almost doubled from 1,204 to 2,330.


Equally disturbing, as the second chart from Anjli Raval’s recent FT analysis confirms, is that Saudi Arabia has been forced to take the main burden of the promised cutbacks. Its 519,000 b/d cut almost exactly matches Opec’s total 517,000 b/d cutback.

Of course, other Opec members will continue to cheer on Saudi Arabia because they gain the benefit of higher prices from its output curbs.

But we would question whether the quota strategy is really the right policy for the Kingdom itself. A year ago, after all, Opec had forecast that its new quotas would “rebalance the oil market” in the first half of this year. When this proved over-optimistic, it expected rebalancing to have been achieved by March 2018. Now, it is suggesting that rebalancing may take until the end of 2018, and could even require further output cuts.

Producers used to shrug off this development, arguing that demand growth in China, India and other emerging markets would secure oil’s future. But they can no longer ignore rising concerns over pollution from gasoline and diesel-powered cars.

India has already announced that all new cars will be powered by electricity by 2030, while China is studying a similar move. China has a dual incentive for such a policy because it would not only support President Xi Jinping’s anti-pollution strategy, but also create an opportunity for its automakers to take a global lead in electric vehicle production.

It therefore seems timely for Prince Mohammed to revert to his earlier approach to the oil price. The rebalancing strategy has clearly not produced the expected results and, even worse, US shale producers are now enthusiastically ramping up production at Saudi Arabia’s expense.

The kingdom’s exports of crude oil to the US fell to just 795,000 b/d in July, while US oil and product exports last week hit a new record level of more than 7.6m b/d, further reducing Saudi Arabia’s market share in key global markets.

The growing likelihood that oil demand will peak within the next decade highlights how Saudi Arabia is effectively now in a battle to monetise its reserves before demand starts to slip away.

Geopolitics also suggests that a pivot away from Russia to China might be opportune. The Opec deal clearly made sense for Russia in the short term, given its continuing dependence on oil revenues. But Russia is never likely to become a true strategic partner for the kingdom, given its competitive position as a major oil and gas producer, and its longstanding regional alliances with Iran and Syria. China, however, offers the potential for a much more strategic relationship, which would allow Saudi Arabia as the world’s largest oil producer to boost its sales to the world’s second-largest oil market.

China also offers a potential solution to the vexed question of the Saudi Aramco flotation, following the recent offer by an unnamed (but no doubt state-linked) Chinese buyer to purchase the whole 5 per cent stake. This would allow Prince Mohammed to avoid embarrassment by claiming victory in the sale while avoiding the difficulties of a public float.

The Chinese option would also help the kingdom access the One Belt, One Road (OBOR) market for its future non-oil production. This option could be very valuable, given that OBOR may well become the largest free-trade area in the world, as we discussed here in June.

In addition, and perhaps most importantly from Prince Mohammed’s viewpoint, the China pivot might well tip the balance within Saudi Arabia’s Allegiance Council, and smooth his path to the throne as King Salman’s successor.

Paul Hodges and David Hughes publish The pH Report.

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Budgeting for the Great Unknown in 2018 – 2020

“There isn’t anybody who knows what is going to happen in the next 12 months.  We’ve never been here before.  Things are out of control.  I have never seen a situation like it.

This comment from former UK Finance Minister, Ken Clarke, aptly summarises the uncertainty facing companies, investors and individuals as we look ahead to the 2018 – 2020 Budget period.  None of us have ever seen a situation like today’s.  Even worse, is the fact that risks are not just focused on the economy, or politics, or social issues.  They are a varying mix of all of these.  And because of today’s globalised world, they potentially affect every country, no matter how stable it might appear from inside its own borders.

This is why my Budget Outlook for 2018 – 2020 is titled ‘Budgeting for the Great Unknown’.  We cannot know what will happen next.  But this doesn’t mean we can’t try to identify the key risks and decide how best to try and manage them.  The alternative, of doing nothing, would leave us at the mercy of the unknown, which is never a good place to be.

RISING INTEREST RATES COULD SPARK A DEBT CRISIS

Central banks assumed after 2008 that stimulus policies would quickly return the economy to the BabyBoomer-led economic SuperCycle of the previous 25 years.  And when the first round of stimulus failed to produce the expected results, as was inevitable, they simply did more…and more…and more.  The man who bought the first $1.25tn of mortgage debt for the US Federal Reserve (Fed) later described this failure under the heading “I’m sorry, America“:

You’d think the Fed would have finally stopped to question the wisdom of QE. Think again. Only a few months later—after a 14% drop in the U.S. stock market and renewed weakening in the banking sector—the Fed announced a new round of bond buying: QE2

• And the Fed was not alone, as the chart shows.  Today, the world is burdened by over $30tn of central bank debt
• The Fed, European Central Bank, Bank of Japan and the Bank of England now appear to “own a fifth of their governments’ total debt
• There also seems little chance that this debt can ever be repaid.  The demand deficit caused by today’s ageing populations means that growth and inflation remain weak, as I discussed in the Financial Times last month

China is, of course, most at risk – as it was responsible for more than half of the lending bubble.  This means the health of its banking sector is now tied to the property sector, just as happened with US subprime. Around one in five of all Chinese apartments have been bought for speculation, not to be lived in, and are unoccupied.

China’s central bank chief, Zhou Xiaochuan, has warned that China risks a “Minsky Moment“, where lenders and investors suddenly realise they have overpaid for their assets, and all rush together for the exits – as in 2008.  Similar risks face the main developed countries as they finally have to end their stimulus programmes:

• Who is now going to replace them as buyers of government debt?
• And who is going to buy these bonds at today’s prices, as the banks back away?
$8tn of government and corporate bonds now have negative interest rates, which guarantee the buyer will lose money unless major deflation takes place – and major deflation would make it very difficult to repay the capital invested

There is only one strategy to manage this risk, and that is to avoid debt.  Companies or individuals with too much debt will go bankrupt very quickly if and when a Minsky Moment takes place.

THE CHINA SLOWDOWN RISK IS LINKED TO THE PROPERTY LENDING BUBBLE

After 2008, it seemed everyone wanted to believe that China had suddenly become middle class by Western standards. And so they chose to ignore the mounting evidence of a housing bubble, as shown in the chart above.

Yet official data shows average incomes in China are still below Western poverty levels (US poverty level = $12060):

•  In H1, disposable income for urban residents averaged just $5389/capita
•  In the rural half of the country, disposable income averaged just $1930
•  The difference between income and expenditure was based on the lending bubble

As a result, average house price/earnings ratios in cities such as Beijing and Shanghai are now more than 3x the ratios in cities such as New York – which are themselves wildly overpriced by historical standards.

Having now been reappointed for a further 5 years, it is clear that President Xi Jinping is focused on tackling this risk.  The only way this can be done is to take the pain of an economic slowdown, whilst keeping a very close eye on default risks in the banking sector.  As Xi said once again in his opening address to last week’s National Congress:

“Houses are built to be inhabited, not for speculation. China will accelerate establishing a system with supply from multiple parties, affordability from different channels, and make rental housing as important as home purchasing.

China will therefore no longer be powering global growth, as it has done since 2008.  Prudent companies and investors will therefore want to review their business models and portfolios to identify where these are dependent on China.

This may not be easy, as the link to end-user demand in China might well be further down the supply chain, or external via a second-order impact.  For example, Company A may have no business with China and feel it is secure.  But it may suddenly wake up one morning to find its own sales under attack, if company B loses business in China and crashes prices elsewhere to replace its lost volume.

PROTECTIONISM IS ON THE RISE AROUND THE WORLD

Trade policy is the third key risk, as the chart of harmful interventions from Global Trade Alert confirms.

These are now running at 3x the level of liberalising interventions since 2008, as Populist politicians convince their voters that the country is losing jobs due to “unfair” trade policies.

China has been hit most times, as its economy became “the manufacturing capital of the world” after it joined the World Trade Organisation in 2001.  At the time, this was seen as being good news for consumers, as its low labour costs led to lower prices.

But today, the benefits of global trade are being forgotten – even though jobless levels are relatively low.  What will happen if the global economy now moves into recession?

The UK’s Brexit decision highlights the danger of rising protectionism. Leading Brexiteer and former cabinet minister John Redwood writes an online diary which even campaigns against buying food from the rest of the European Union:

There are many great English cheese (sic), so you don’t need to buy French.

No family tries to grow all its own food, or to manufacture all the other items that it needs.  And it used to be well understood that countries also benefited from specialising in areas where they were strong, and trading with those who were strong in other areas.  But Populism ignores these obvious truths.

•  President Trump has left the Trans-Pacific Partnership, which would have linked major Pacific Ocean economies
•  He has also said he will probably pull out of the Paris Climate Change Agreement
•  Now he has turned his attention to NAFTA, causing the head of the US Chamber of Commerce to warn:

“There are several poison pill proposals still on the table that could doom the entire deal,” Donohue said at an event hosted by the American Chamber of Commerce of Mexico, where he said the “existential threat” to NAFTA threatened regional security.

At the moment, most companies and investors seem to be ignoring these developments, assuming that in the end, sense will prevail.  But what if they are wrong?  It seems highly likely, for example, that the UK will end up with a “hard Brexit” in March 2019 with no EU trade deal and no transition period to enable businesses to adjust.

Today’s Populist politicians don’t seem to care about these risks. For them, the allure of arguing for “no deal”, if they can’t get exactly what they want, is very powerful. So it would seem sensible for executives to spend time understanding exactly how their business might be impacted if today’s global supply chains came to an end.

POLITICAL CHAOS IS GROWING AS PEOPLE LOSE FAITH IN THE ELITES
The key issue underlying these risks is that voters no longer believe that the political elites are operating with their best interests at heart.  The elites have failed to deliver on their promises, and many families now worry that their children’s lives will be more difficult than their own.  This breaks a century of constant progress in Western countries, where each generation had better living standards and incomes.  As the chart from ipsos mori confirms:

•  Most people in the major economies feel their country is going in the wrong direction
•  Adults in only 3 of the 10 major economies – China, India and Canada – feel things are going in the right direction
•  Adults in the other 7 major economies feel they are going in the wrong direction, sometimes by large margins
•  59% of Americans, 62% of Japanese, 63% of Germans, 71% of French, 72% of British, 84% of Brazilians and 85% of Italians are unhappy

This suggests there is major potential for social unrest and political chaos if the elites don’t change direction.  Fear of immigrants is rising in many countries, and causing a rise in Populism even in countries such as Germany.

CONCLUSION
“Business as usual” is always the most popular strategy, as it means companies and investors don’t have to face the need to make major changes.  But we all know that change is inevitable over time.  And at a certain moment, time can seem to literally “stand still” whilst sudden and sometimes traumatic change erupts.

At such moments, as in 2008, commentators rush to argue that “nobody could have seen this coming“.  But, of course, this is nonsense.  What they actually mean is that “nobody wanted to see this coming“.  The threat from subprime was perfectly obvious from 2006 onwards, as I warned in the Financial Times and in ICIS Chemical Business, as was 2014’s oil price collapse. Today’s risks are similarly obvious, as the “Ring of Fire” map describes.

You may well have your own concerns about other potential major business risks. Nobel Prizewinner Richard Thaler, for example, worries that:

“We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping.”

We can all hope that none of these scenarios will actually create major problems over the 2018 – 2020 period. But hope is not a strategy, and it is time to develop contingency plans.  Time spent on these today could well be the best investment you will make. As always, please do contact me at phodges@iec.eu.com if I can help in any way.

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President Xi focuses on pollution, not growth, as key Party Congress nears

Beijing pollution Feb14

Imagine living in the capital city of a major country, and suffering the level of pollution shown in the above photo on a regular basis.  We used the photo in chapter 6 of Boom, Gloom and the New Normal when we highlighted how pollution was inevitably going to move up the political agenda in China. Controversial at the time, it warned:

Recent growth in China and India has come at a price: Poor air quality, chronic water shortages and deforestation.”

By February 2014, the pressure to act was becoming almost overwhelming as:

“The problems have worsened, to the point where almost everyone now agrees that they are creating a major political problem. The new leadership simply has to solve this, if it wants to remain in office. Beijing and the 6 northern provinces have now been shrouded in smog for 6 days, and on Wednesday the US embassy reported that the levels of PM2.5, the small particles that pose the greatest risk to human health, were “beyond index” at 512.

Guangdong province, close to Hong Kong, had already moved to clean up.  But other provinces did little or nothing, as officials worried about the likely impact on jobs. A major part of the problem was that the economy is the Premier’s responsibility, and Premier Li has been more worried about maintaining growth via stimulus programmes.

This year, however, Xi finally lost patience ahead of next month’s 5-yearly People’s Congress – at which he will be renominated for another 5-year term.  Having signed China up to the Paris Agreement on climate change in December 2015, he seized control of the economic agenda, as I noted in the Financial Times:

Xi knows that reducing pollution, rather than maintaining economic growth, has become key to continued Communist Party rule.  The recent rapid elevation of Beijing’s mayor, Cai Qi, to become party chief for the city is further confirmation of the high priority now being given to tackling air pollution and stabilising house prices.

“Taken together, these policies represent a paradigm shift from those put in place 40 years ago by Deng Xiaoping after Mao’s death in 1976. This shift has critically important implications, as it means growth is no longer the main priority of China’s leadership. In turn, this means that stimulus programmes of the type unleashed in 2012, and on a more limited basis by Premier Li last year, are a thing of the past.”

Since then, the Beijing area, and surrounding provinces such as Hebei and Henan, have become a centre of the battle against pollution.  One key development has been the use of thousands of drones to spot, and measure air and water pollution, and then identify and photograph the culprits. As state-controlled Xinhua reported last week:

“A total of 599 companies, mainly construction materials, furniture, chemicals, packaging and printing, were relocated out of the capital, said the Beijing municipal commission of development and reform.  Beijing also closed 2,543 firms and ordered 2,315 firms to make changes. About 73% had pollution issues.

Similarly, a senior chemical industry executive told me last week:

“I was in/near Cangzhou the other day (another city on the list) where the government have created a large National Level Economic Zone including a dedicated chemical “park” to accommodate the companies that are being cleared out of Beijing and surrounds. This was an otherwise nondescript flatland whose only previous claim to fame was a Mao era collaboration with then Czechoslovakia to make tractors.

China lend Sept17

The war on pollution has another side to it, of course, as it marks the end of the “growth at any cost” economic model.

As a result, realism is finally returning to discussion about China’s real growth potential.  As last month’s IMF Report on China noted, GDP growth had only averaged 7.3% over the 5 years to 2016 because of stimulus: without this, growth would have been just 5.3%.  As a result, the IMF also highlighted an increasing risk of “a possible sharp decline in growth in the medium term”, as well as a need to boost domestic consumption by reducing savings.

This is a welcome development. Too many companies and analysts have indulged in wishful thinking, wanting to believe China had suddenly become middle-class by Western standards.  In reality, as the second chart shows, the growth surge was due to $20tn of stimulus lending via official and shadow banking channels.

At its peak, between 2009 – 2013, this lending reached 3.2x official GDP.  And GDP itself was probably also over-stated for internal political reasons, as Communist Party officials were routinely judged for promotion on their success in generating GDP growth.  Now the pendulum has swung the other way, as the Caixin business magazine has reported:

In a document jointly released by the Ministry of Environmental Protection and nine other ministry-level bodies, if a city does not achieve 60% of the emission reduction target, the city’s vice mayor will be held responsible.  If the city achieves less than 30% of its target, the mayor will be held responsible; and if the PM2.5 level ends up increasing instead of falling over the winter, the party secretary of the city will be held responsible.

“Possible punishment includes party disciplinary or administrative punishments, the document says.”

Large economies are like super-tankers, they take a long time to change course.  As I noted nearly 2 years ago, China is now attempting to move in a radically new direction, away from export-driven growth and infrastructure spending – and towards a New Normal economy based on the mobile internet:

“The winners are developing services-led businesses focused on China’s New Normal markets – such as those aimed at boosting living standards in the poverty-stricken rural areas, or for environmental clean-up. The losers will be those who cling to the hope that more stimulus is just around the corner, and that China’s Old Normal will somehow return.”

Those who have done well under the old regime, like the Party heads focused on job-creation and the opportunities that it created for large-scale corruption, will inevitably fight hard to preserve their way of life.  Next month’s Congress will therefore be critical in assessing just how much power Xi will have to pursue his reform policies in his second term.

As I noted a year ago, this Congress will settle key questions.  Will Premier Li gain a second term, and continue to be able to obstruct reform? Will anti-corruption tsar Wang maintain his position on the all-powerful Politburo Standing Committee, despite being over the nominal age limit?

The Congress is therefore likely to the most important meeting since 1997, when Jiang Zemin gained re-appointment for his second term as President and led China out of poverty via membership of the World Trade Organisation.  Now, as set out in the China 2030 Report (published when Xi became President), Xi has to led China in a new direction.

Otherwise, he will be unable to achieve his twin goals of

□   Making China a “moderately prosperous society” by 2021 (the centenary of the Chinese Communist Party)
□   Making it a “fully developed, rich and powerful nation” by 2049 (the centenary of the People’s Republic), and returned to its historical status as the Middle Kingdom via his ‘One Belt, One Road’ project.

 

 

China’s used cars put a dent in global industry

China is now developing a used car market for the first time in its history.  This means the end of global auto sales growth, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog

Autos Top 7 Aug17

China’s car market has been key to the recovery in global auto sales growth since 2009, as the chart shows.

Its passenger car sales in the first half of each year have risen threefold between 2007 and 2017, from 3.1m to 11.3m today, while sales in the other top six markets have only just managed to recover to 2007 levels.

But now major change is coming to China’s market from two directions.

The first sign of change is the fact that H1 sales rose just 2.7% this year. This is the lowest increase since our records began in 2005 (when sales were just 1.8m), and compares with an 11% rise last year.

Official forecasts for full-year growth have also been revised down, to between 1% and 4%, by the manufacturers’ association. A further sign of the slowdown is the rise in price discounting, with Ford China suggesting prices were down 4% on average in the first half.

The second change may be even more important from a longer-term perspective. It seems likely that China’s used car market is poised for major growth. As the second chart shows, only 10m used cars were sold last year, versus 24m new cars.

Yet used car sales are typically between 2 and 2.5 times new car sales in other large markets such as the US, where 2016 saw 39m used car sales versus 18m new car sales.

China autos Aug17The background to this unusual situation is that China’s new car sales were relatively small until the government’s stimulus programme began in 2009. Their quality was also poor, as most cars were produced domestically and only lasted an average of three years. As a result:

 The auto market only really began to take off in 2009 under the influence of the stimulus packages, when annual new car sales jumped 53% from 6.7m to 10.3m. About 200m Chinese were able to drive a car in that year, and the stimulus programme suddenly provided them with the cash to buy one
 Used car sales were much slower to develop, as it took time for the introduction of western manufacturing techniques to gradually extend the average life of a car from 3 years in 2012 to 4.5 years today. But now the pace of change is rising, and it is expected to reach 10 years by 2020

The chart also shows our forecasts for the used car market out to 2020, when we expect used car sales to equal new car sales at 23.5m. This would still only represent a 1x ratio, but the forecast is in line with a new report from Guangzhou-based analysts Piston, who told WardsAuto:

“The used-car market in China is expected to have an explosion in the coming decade, because the ratio of used to new is [the opposite of that in] the US.

One sign of the change under way was seen last month, when Guazi.com, China’s largest used car trading site, was able to raise a further $400m from investors to expand its service.

Guazi, like BMW and others, have seen that the used car market offers very favourable prospects for growth prospect — as long as attention is paid to boosting buyer confidence by providing sensible warranties and service packages.

Local governments have also played their part under pressure from central government. The state-owned China Daily reports that 135 local authorities have now removed barriers that prevented used cars from one province being sold in another. The effect of these changes is having an effect, with used car sales in January-May jumping 21% versus 2016.

Such strong growth rates, and the slowdown in new car sales, suggest China’s auto market may have reached a tipping point.

All good things come to an end eventually, and it seems prudent to assume that China will no longer be the main support for global auto sales. We expect China’s new car sales to plateau because of the combined impact of the end of stimulus (as discussed here in June), and the rise of used car sales, as these will inevitably cannibalise their volumes to some extent.

Clearly this is not good news for those western manufacturers that have made China the focus of their growth plans in recent years. And there may be worse news in store, given the government’s determination to combat urban pollution by promoting sales of electric vehicles and car-sharing.

Yet it will be good news for those prepared to develop new, more service-related business models. Used-car sales themselves can be highly profitable, while servicing and spare parts supply are likely to become equally attractive opportunities.

Paul Hodges publishes The pH Report.

Oil prices under pressure as US oil/product exports ramp up

US oil exports May17

On Monday, I discussed how OPEC abandoned Saudi Oil Minister Naimi’s market share strategy during H2 last year.

Naimi’s strategy had stopped the necessary investment being made to properly exploit the new US shale discoveries. But this changed as the OPEC/non-OPEC countries began to talk prices up to $50/bbl. As CNN reported last week:

Cash is pouring into the Permian, lured by a unique geology that allows frackers to hit multiple layers of oil as they drill into the ground, making it lucrative to drill in the Permian even in today’s low prices.”

  Private equity poured $20bn into the US shale industry in Q1
  Major oil companies were also active, with ExxonMobil spending $5.6bn in February

US oil/product inventories have already risen by 54 million barrels since January last year and are, like OECD inventories, at record levels. And yet now, OPEC and Russia have decided to double down on their failing strategy by extending their output quotas to March 2018, in order to try and maintain a $50/bbl floor price. US shale producers couldn’t have hoped for better news.   As the chart shows:

  US inventories would be even higher if the US wasn’t already exporting nearly 5 million barrels/day of oil products
  It is also exporting 500 kb/d of oil since President Obama lifted the ban in December 2015
  Nobody seems to pay much attention to this dramatic about-turn as they instead obsess on weekly inventory data
  But these exports are now taking the fight to OPEC and Russia in some of their core markets around the world

None of this would have happened if Naimi’s policy had continued.  Producers could not have raised the necessary capital with prices below $30/bbl.  But now they have spent the capital, cash-flow has become their key metric.

US rigs May17The second chart confirms the turnaround that has taken place across the US shale landscape, as the oil rig count has doubled over the past year. Drilling takes between 6 – 9 months to show results in terms of oil production, and so the real surge is only just now beginning.  Equally important, as the Financial Times reports, is that today’s horizontal wells are far more productive:

“This month 662 barrels/d will be produced from new wells in the Permian for every rig that is running there, according to the US government’s Energy Information Administration. That is triple the rate of 217 b/d per rig at the end of 2014.”

Before too long, the oil market will suddenly notice what is happening to US shale production, and prices will start to react.  Will they stop at $30/bbl again? Maybe not, given today’s record levels of global inventory.

As the International Energy Agency (IEA) noted last month, OECD stocks actually rose 24.1mb in Q1, despite the OPEC/non-OPEC deal. And, of course, as the IEA has also noted, the medium term outlook for oil demand has also been weakening as China and India focus on boosting the use of Electric Vehicles.

The current OPEC/non-OPEC strategy highlights the fact that whilst the West has begun the process of adapting to lower oil prices, many oil exporting countries have not.  As Nick Butler warns in the Financial Times:

“Matching lower revenues to the needs of growing populations who have become dependent on oil wealth will not be easy. It is hard to think of an oil-producing country that does not already have deep social and economic problems. Many are deeply in debt.

“In Nigeria, Venezuela, Russia and even Saudi Arabia itself the latest fall, and the removal of the illusion that prices are about to rise again, could be dangerously disruptive. The effects will be felt well beyond the oil market.”

US Permian’s shale oil surge highlights OPEC’s failed strategy

Pioneer May17
OPEC and Russia made a massive mistake last November when when they decided to try and establish a $50/bbl floor for world oil prices.  And now they have doubled down on their mistake by extending the deal to March 2018. They have ignored 4 absolutely critical facts:

  Major US shale oil producers were already reducing production costs below $10/bbl, as the Pioneer chart confirms
  The US now has more oil reserves than Saudi Arabia or Russia, with “Texas alone holding more than 60bn barrels
  At $30/bbl, US producers couldn’t raise the capital required to exploit these newly-discovered low-cost reserves
  But at $50/bbl, they could

Former Saudi Oil Minister Ali Naimi understood this very well.  He also understood that OPEC producers therefore had to focus on market share, not price, as Bloomberg reported:

“Naimi, 79, dominated the debate at OPEC’s November 2014 meeting, according to officials briefed on the closed-door proceedings. He told his OPEC counterparts they should maintain output to protect market share from rising supplies of U.S. shale oil.”

Permian rigs May17Naimi’s strategy was far-sighted and was working.  The key battleground for OPEC was the vast Permian Basin in Texas – its Wolfgang field alone held 20bn barrels of oil, plus gas and NGLs. By January 2016, oil prices had fallen to $30/bbl and the Permian rig count had collapsed, as the second chart confirms:

  Naimi had begun his price war in August 2014, and reinforced it at OPEC’s November 2014 meeting
  Oil companies immediately began to reduce the number of highly productive horizontal rigs in the Permian basin
  The number of rigs peaked at 353 in December 2014 and there were only 116 operating by May 2016

But then Naimi retired a year ago, and with him went his 67 years’ experience of the world’s oil markets.  Almost immediately, OPEC and Russian oil producers decided to abandon Naimi’s strategy just as it was delivering its objectives.  They thought they could effectively “have their cake and eat it” by ramping up their production to record levels, whilst also taking prices back to $50/bbl via a new alliance with the hedge funds, as Reuters reported:

“OPEC and some of the most important hedge funds active in commodities reached an understanding on oil market rebalancing during informal briefings held in the second half of 2016…. OPEC effectively underwrote the fund managers’ bullish positions by providing the oil market with detail about output levels and public messaging about high levels of compliance”.

This gave the shale producers the window of opportunity they needed.  Suddenly, they could hedge their production at a highly profitable $50/bbl – and so they could go to the banks and raise the capital investment that they needed.

As a result, the number of rigs in the Permian Basin has nearly trebled.  At 309 last week, the rig count is already very close to the previous peak.

The Permian is an enormous field. Pioneer’s CEO said recently he expects it to rival Ghawar in Saudi Arabia, with the ability to pump 5 million barrels/day. It is also very cheap to operate, once the capital has been invested.  And it is now too late for OPEC to do anything to stop its development.

On Thursday, I will look at what will likely happen next to oil prices as the US drilling surge continues.