Back in 2015, veteran Saudi Oil Minister Ali Naimi was very clear about Saudi’s need to adopt a market share-based pricing policy:
“Saudi Arabia cut output in 1980s to support prices. I was responsible for production at Aramco at that time, and I saw how prices fell, so we lost on output and on prices at the same time. We learned from that mistake.”
As Naimi recognised, high oil prices created a short-term win for Saudi’s budget between 2011-4. But they also allowed US frackers to enter the market – posing a major threat to Saudi’s control – whilst also reducing overall demand. And his “boss”, Crown Prince Mohammed bin Salman (MbS) agreed with him, saying:
“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.”
Today, however, Saudi oil policy has reversed course, with MbS now trying to push prices towards the $80/bbl level assumed in this year’s Budget.
Saudi’s dilemma is that its growing population, and its need to diversify the economy away from oil, requires increases in public spending. As a result, it has conflicting objectives:
- Its long-term need is to defend its market share, to guarantee its ability to monetise its vast oil reserves
- But its short-term need is to support prices by cutting production, in order to fund its spending priorities
The result, as the chart above confirms, is that prices are now at levels which have almost always led to recession in the past. It compares the total cost of oil* as a percentage of global GDP with IMF data for the economy, with the shaded areas showing US recessions. The tipping point is when the total cost reaches 3% of global GDP. And this is where we are today.
The reason is that high oil prices reduce discretionary spending. Consumers have to drive to work and keep their homes warm (and cool in the summer). So if oil prices are high, they have to cut back in other areas, slowing the economy.
CENTRAL BANK STIMULUS MADE OIL PRICES “AFFORDABLE” IN 2011-2014
There has only been one occasion in the past 50 years when this level failed to trigger a recession. That was in 2011-14, when all the major central bank stimulus programmes were in full flow, as the left-hand chart shows.
They were creating tens of $tns of free cash to support consumer spending. But at the same time, of course, they were creating record levels of consumer debt, as the right-hand chart shows from the latest New York Federal Reserve’s Household Debt Report. It shows US household debt is now at a record $13.54tn. And it confirms that consumers have reached the end of the road in terms of borrowing:
“The number of credit inquiries within the past six months – an indicator of consumer credit demand – declined to the lowest level seen in the history of the data.”
SAUDI ARABIA IS NO LONGER THE SWING SUPPLIER IN OIL MARKETS
Oil prices are therefore now on a roller-coaster ride:
- Saudi tried to push them up last year, but this meant demand growth slowed and Russian/US output rose
- The rally ran out of steam in September and Brent collapsed from $85/bbl to $50/bbl in December
Now Saudi is trying again. It agreed with OPEC and Russia in December to cut production by 1.2mbd – with reductions to be shared between OPEC (0.8 million bpd) and its Russia-led allies (0.4 million bpd). But as always, its “allies” have let it down. So Saudi has been forced to make up the difference. Its production has fallen from over 11mbd to a forecast 9.8mbd in March.
Critically however, as the WSJ chart shows, it has lost its role as the world’s swing supplier:
Of course, geo-politics around Iran or Venezuela or N Korea could always intervene to support prices. But for the moment, the main support for rising prices is coming from the hedge funds. As Reuters reports, their ratio of long to short positions in Brent has more than doubled since mid-December in line with rising stock markets.
But the hedge funds did very badly in Q4 last year when prices collapsed. And so it seems unlikely they will be too bold with their buying, whilst the pain of lost bonuses is so recent.
Companies and investors therefore need to be very cautious. Saudi’s current success in boosting oil prices is very fragile, as markets are relying on more central bank stimulus to offset the recession risk. If market sentiment turns negative, today’s roller-coaster could become a very bumpy ride.
Given that Saudi has decided to ignore al-Naimi’s warning, the 2014-15 experience shows there is a real possibility of oil prices returning to $30/bbl later this year.
*Total cost is number of barrels used multiplied by their cost
Today, we have “lies, fake news and statistics” rather than the old phrase “lies, damned lies and statistics”. But the general principle is still the same. Cynical players simply focus on the numbers that promote their argument, and ignore or challenge everything else.
The easiest way for them to manipulate the statistics is to ignore the wider context and focus on a single “shock, horror” story. So the chart above instead combines 5 “shock, horror” stories, showing quarterly oil production since 2015:
- Iran is in the news following President Trump’s decision to abandon the nuclear agreement, which began in July 2015. OPEC data shows its output has since risen from 2.9mbd in Q2 2015 to 3.8mbd in April – ‘shock, horror’!
- Russia has also been much in the news since joining the OPEC output agreement in November 2016. But in reality, it has done little. Its production was 11mbd in Q3 2016 and was 11.1mbd in April- ‘shock, horror’!
- Saudi Arabia leads OPEC: its production has fallen from 10.6mbd in Q3 2016 to 9.9mbd in April- ‘shock, horror’!
- Venezuela is an OPEC member, but its production decline began long before the OPEC deal. The country’s economic collapse has seen oil output fall from 2.4mbd in Q4 2015 to just 1.5mbd in April- ‘shock, horror’!
- The USA, along with Iran, has been the big winner over the past 2 years. Its output initially fell from 9.5mbd in Q1 2015 to 8.7mbd in Q3 2016, but has since soared by nearly 2mbd to 10.6mbd in April- ‘shock, horror’!
But overall, output in these 5 key countries rose from 35.5mbd in Q1 2015 to 36.9mbd in April. Not much “shock, horror” there over a 3 year period. More a New Normal story of “Winners and Losers”.
So why, you might ask, has the oil price rocketed from $27/bbl in January 2016 to $45/bbl in June last year and $78/bbl last Friday? Its a good question, as there have been no physical shortages reported anywhere in the world to cause prices to nearly treble. The answer lies in the second chart from John Kemp at Reuters:
- It shows combined speculative purchases in futures markets by hedge funds since 2013
- These hit a low of around 200mbbls in January 2016 (2 days supply)
- They then more than trebled to around 700mbbls by December 2016 (7 days supply)
- After halving to around 400mbbls in June 2017, they have now trebled to 1.4mbbls today (14 days supply)
Speculative buying, by definition, isn’t connected with the physical market, as OPEC’s Secretary General noted after meeting the major funds recently: “Several of them had little or no experience or even a basic understanding of how the physical market works.”
This critical point is confirmed by Citi analyst Ed Morse: “There are large investors in energy, and they don’t care about talking to people who deal with fundamentals. They have no interest in it.”
Their concern instead is with movements in currencies or interest rates – or with the shape of the oil futures curve itself. As the head of the $8bn Aspect fund has confirmed:
“The majority of our inputs, the vast majority, are price-driven. And the overwhelming factor we capitalise on is the tendency of crowd behaviour to drive medium-term trends in the market.” (my emphasis).
OIL PRICES ARE NOW AT LEVELS THAT USUALLY LEAD TO RECESSION
The hedge funds have been the real winners from all the “shock, horror” stories. These created the essential changes in “crowd behaviour”, from which they could profit. But now they are leaving the party – and the rest of will suffer the hangover, as the 3rd chart warns:
- Oil prices now represent 3.1% of global GDP, based on latest IMF data and 2018 forecasts
- This level has been linked with a US recession on almost every occasion since 1970
- The only exception was post-2009 when China and the Western central banks ramped up stimulus
- The stimulus simply created a debt-financed bubble
The reason is simple. People only have so much cash to spend. If they have to spend it on gasoline and heating their home, they can’t spend it on all the other things that drive the wider economy. Chemical markets are already confirming that demand destruction is taking place.:
- Companies have completely failed to pass through today’s high energy costs. For example:
- European prices for the major plastic, low density polyethylene, averaged $1767/t in April with Brent at $72/bbl
- They averaged $1763/t in May 2016 when Brent was $47/bbl (based on ICIS pricing data)
Even worse news may be around the corner. Last week saw President Trump decide to withdraw from the Iran deal. His daughter also opened the new US embassy to Jerusalem. Those with long memories are already wondering whether we could now see a return to the geopolitical crisis in summer 2008.
As I noted in July 2008, the skies over Greece were then “filled with planes” as Israel practised for an attack on Iran’s nuclear facilities. Had the attack gone ahead, Iran would almost certainly have closed the Strait of Hormuz. It is just 21 miles wide (34km) at its narrowest point, and carries 35% of all seaborne oil exports, 17mb/d.
As Mark Twain wisely noted, “history doesn’t repeat itself, but it often rhymes”. Prudent companies and investors need now to look beyond the “market-moving, shock, horror” headlines in today’s oil markets. We must all learn to form our own judgments about the real risks that might lie ahead.
Given the geopolitical factors raised by President Trump’s decision on Iran, I am pausing the current oil forecast.
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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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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.
The myth of oil market rebalancing has been a great money-maker for financial markets. Hedge funds were the first to benefit in H2 last year, as Reuters has reported, when:
“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. In return, the funds delivered an early payoff for OPEC through higher oil prices and a shift from contango to backwardation that should have helped drain excess crude stocks.”
Then the investment banks had their day in the sun, raising $19.8bn in Q1 for private equity players anxious to bet on the idea that prices had stabilised at $50/bbl for US shale oil production. This was 3 times the amount raised in Q1 last year, when the price was recovering from its $27/bbl low.
There was only one flaw in the story – the rebalancing never happened. As the chart shows, OECD inventories are now heading back to their previous record highs, having risen 38.5mb since January’s OPEC deal began. As always, most countries failed to follow through on their commitments – non-OPEC compliance was just 66% in March, and Russia is still producing 50kpd more than its quota this month.
US inventories have also continued to rise, hitting all-time peaks, as the second chart confirms. Stocks would be even higher if US crude oil exports hadn’t surged by 90% versus last year to reach 706bpd this month. This is hardly surprising. Major cost-cutting over the past 3 years means that a company such as ExxonMobil now has an average cash operating cost of less than $10/bbl.
US producers have been laughing all the way to the bank, as the third chart confirms, showing the recovery in the US drilling rig count. Not only have they been able to hedge their output into 2019 at today’s artificially high prices. But they have also been able to ramp up their use of modern, highly efficient horizontal rigs. These now dominate drilling activity, and are a record 84% of the total in use – reversing the ratio seen before shale arrived.
It doesn’t take a rocket scientist to work out what will likely happen next:
US production and exports will keep rising as all the new rigs are put to work – there are already 5500 drilled but uncompleted wells waiting to come onstream. Meanwhile, US demand will likely hit a seasonal peak – Memorial Day on 29 May usually marks the moment when refiners finish building inventory ahead of the US driving season
China’s slowing economy will not provide much support. It became a net exporter of fuel products in Q4 last year and February data showed net gasoline exports at 1.05 million tonnes, as they jumped 77% versus 2016. Diesel exports were also up 67% as refiners followed the US in trying to reduce their domestic supply glut
India’s domestic demand is still suffering from the after-effects of the demonetisation programme. It was down 4.5% in January, and was still down 0.6% in March versus a year ago. Japan’s demand is also down, with the government expecting it to fall 1.5%/year through 2022 due to the combined impact of its ageing population and increasing fuel efficiency. S Korean demand is also expected to continue falling for similar reasons
OPEC may well extend its quotas for another 6 months, but this will just give more support to US shale producers. And within OPEC, Iraq plans to boost output to 5mbd by year-end, versus 4.57mbd in February, whilst Libya aims to double its March output of 622kbd, and Iran has already increased its exports to 3mbd for the first time since 1979
Unless geopolitical events intervene, it is therefore hard to see how the myth that the oil market is now rebalancing can be sustained for much longer.