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.
The 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.”
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.”
Naimi’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.
If asked about the outlook for prices, oil company CEOs normally duck the question. And they certainly never disagree in public with Saudi Arabia, the world’s leading oil producer. This is what makes the recent speech by ExxonMobil CEO, Rex Tillerson, so interesting:
“I don’t quite share the same view that others have that we are somehow on the edge of a precipice. I think because we have confirmed viability of very large resource base in North America … that serves as enormous spare capacity in the system. It doesn’t take mega-project dollars and it can be brought on line much more quickly than a 3-4 year project. Never bet against the creativity and tenacity of our industry.”
This was a clear contrast with the earlier view of Saudi Energy Minister, Khalid al-Falih, at the same conference:
“Market forces are clearly working. After testing a period of sub $30 prices the fundamentals are improving and the market is clearly balancing. On the supply side, non-OPEC supply growth has reversed into declines due to major cuts in upstream investments and the steepening of decline rates. Without investment, that trend is likely to accelerate with the passage of time, to the point that many analysts are now wending warning bells over future supply shortfalls and I am in that camp.”
The key issue is that energy output is not just about oil prices. OPEC and non-OPEC producers are in a 3-dimensional battle for market share. Not only do they (a) have to compete with each other, but they also (b) have to remember that coal is still critically important in many countries. And then, there is (c) the climate change issue.
China is the obvious example of a major economy where power supply is still dominated by coal. But even in the US, coal still plays a major role, as the chart above confirms:
The two leading coal producers, Peabody and Arch, went bankrupt 6 months ago
But as I discussed at the time, this did not mean their mines stopped working or that coal prices soared
They are still working normally, as local power suppliers cannot easily switch to oil or gas, given their location
As the Wall Street Journal reported on Monday:
“Energy investors have long hoped that falling prices would solve themselves by driving producers into bankruptcy and stanching the flood of excess supply, but it hasn’t worked out that way”.
A second dimension is added by the dynamics of shale oil production, as the chart from the International Energy Agency highlights:
As I argued 2 years ago in “Saudi Arabia needs much lower oil prices“, Saudi never expected to close down US shale production
Saudi depends for its defence on US military support, and this support would be withdrawn if it was targeting a critical US industry
Saudi also has vast oil reserves, and it knows perfectly well that the world is moving away from fossil fuels
It therefore needs to adopt a demand-led policy, as others will instead monetise their reserves at Saudi’s expense
Saudi’s dilemma is that the world has reached, or may even be past, the period of peak oil demand, with the COP21 ratification process now complete. This is the 3rd dimension of the issue, given that COP 21 agreed to move away from fossil fuels towards renewables, and to promote much greater energy conservation.
Of course, both Tillerson and Saudi Arabia recognise these realities. But they also have to respond to the needs of their key constituencies. In EM’s case, this means recognising that investors expect them to be able to produce oil at ever-lower costs. In Saudi’s case, this means going along with OPEC pressure for output cutbacks.
It would be very dangerous for Saudi to stand out against pressure from other OPEC producers and refuse to support the idea of a production freeze. It was therefore very helpful for al-Falih that Tillerson provided “cover” for the inevitable failure of the policy. Saudi cannot now be blamed, if it turns out that prices end up lower, rather than higher.
80-year olds are allowed to retire, even if they have to wait a year for final permission to be given. But it seems a simple headline saying “Saudi Oil Minister retires after 69 year career” is not “exciting” enough in today’s media world? So perhaps we can’t be too surprised to find some of the world’s media using headlines such as:
- “Saudi Arabia just fired its oil minister”
- “Saudi Arabia Dismisses Its Powerful Oil Minister Ali al-Naimi”
But it is still disappointing that a desire for “clicks” should over-ride the facts, particularly on such a critical issue.
It has, after all, been common knowledge that the 80-year old Naimi wanted to retire a year ago, after the death of Saudi King Abdullah. He was only persuaded to stay on to provide continuity. Now, just before Ramadan begins on 7 June, is an ideal moment for the long-planned handover to Saudi Aramco chairman Khalid al-Falih to take place.
One benefit of his year-long lead-in to retirement was that Naimi was able to give a “retirement interview” to Daniel Yergin at the IHS/CERA conference in February. This was a tour de force of everything that Naimi had seen and learnt during his 69-year career in the oil industry, which began when he joined Saudi Aramco as an office boy in 1947.
The question-and-answer session with Yergin was highly revealing of Naimi’s and Saudi thinking on the outlook for oil prices, particularly when he dismissed suggestions that OPEC production might be cut to rebalance the market.
Arguing that this decision was made in November 2014, he described the freeze concept as being modest in scope, even it it was possible to make it happen, due to the “lack of trust” between the major producers:
“A freeze is the beginning of a process and that means if we can get all the biggest producers not to add additional barrels, then this high inventory we have now will probably decline in due time, its going to take time. It is not like cutting production, that is not going to happen, because not many countries are going to deliver even if they say they will cut production, they will not deliver. So there is no sense in wasting our time seeking production cuts, they will not happen.”
Today it is clear that even the freeze concept has been abandoned. So in terms of oil market developments,now is a sensible moment for Naimi to move into his well-deserved retirement. But lets be clear. He wasn’t fired or dismissed.
Equally important is that the change of personnel doesn’t mean any change is likely in Saudi oil policy. This has always been a slow-moving process, controlled at the highest level of the government. And as Naimi explained to Yergin, the key decisions were made as long ago as November 2014.
The fact that even a freeze has proved impossible to agree, reconfirms the rationale for the decision.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 57%
Naphtha Europe, down 53%. “Arbitrage window to Asia shut”
Benzene Europe, down 53%. “Market is still facing the structural challenges of limited liquidity”
PTA China, down 40%. “Weaker upstream feedstock prices and diminished buying sentiments dampened discussion levels.”
HDPE US export, down 27%. “Talk of falling values in a few Latin American countries.”
¥:$, down 5%
S&P 500 stock market index, up 5%