That the sudden fall came amidst the industry convention CERAWeek 2017 in Houston, where representatives and spokesmen hobnobbed and prognosticated, may only have been a coincidence and certainly added to the week’s excitement.
But the narrative in world oil since Autumn 2015, pitting OPEC production against U.S. shale, has stayed firmly in place, prompting a new round of questions: with the price unsteady and U.S. production rising again, is another OPEC production cut on the horizon? How far will OPEC, which has already cut 1.8 million bpd, go towards allowing a recovery in price, up to and including “making room” for U.S. shale producers?
Despite some reassuring words from OPEC leaders, shrugging off the threat of competition from the U.S. and instead characterizing it as a boon for the global market, analysts have largely stuck with the story that OPEC cuts from November have been offset by rising production from the U.S., primarily shale oil from the Permian Basin.
For several months, hopes rested on OPEC’s high level of compliance to keep prices buoyant. Despite weak fundamentals and persistent evidence that a glut remained on the global market, investors piled into long positions and forecasts swayed between $60 and $70 per barrel. Those predictions now look more suspect, after a single report sent the price tumbling.
There is a good chance the reaction was extreme, and that the price will claw its way back up. There are also long-term concerns, voiced recently by the IEA, that a lack of investment and slow reserve replacement rate will mean much, much higher prices in the years ahead.
In the short-term, however, the key question will be whether OPEC decides to lengthen the period of production cuts, or even to order a second round of deeper cuts to bring the price back up. There was some debate in early March, as U.S. production looked set to rise and inventories climbed, that OPEC would consider extending the cuts (which were only meant to last six months) past its May meeting this year.
The original cuts in November, according to Bloomberg, were meant to send the market into backwardation, placing a premium on short-term supply and increasing OPEC revenues while cutting into those of rival producers. During a period of cuts, inventories are reduced: OECD stocks fell by 800,000 bpd at the end of 2016, the biggest fall in years, and total inventories were below 3 billion barrels for the first time in over a year. Contango looked to be tightening, suggesting a closer market and bullish forecasts predicted a strong rally later in 2017.
But the effect of the cuts was much more short-lived than expected, and the fall in prices this week may indicate a turning point in the on-going drama of global prices. Bearish options are getting more attention and short sellers may be crowding into the oil market. Speculation that prices would reach $70 by years end without further OPEC cuts now looks a tad optimistic.
The immediate cause of the fall seems to be the untrammeled growth in U.S. shale production. Harold Hamm, CEO of Continental Resources, argued at CERAWeek 2017 that further growth in shale would “kill” the oil market if it wasn’t measured and controlled. Continental is ramping up its exploration budget for 2017, as is Hess and Exxon (which now holds major territory in the Permian Basin). Hamm’s warning seems a little hypocritical, considering his interest in U.S. shale, but it may well prove prescient: rampant production from the U.S. could send the price down even further.
But what if OPEC decides to deepen cuts? It’s a possibility that, for now, is being discounted by OPEC spokesmen. Saudi oil Minister Khalil Al-Falih said it was premature to consider further cuts, and claimed his country is unwilling to bear the brunt of cuts (as it has done so far; Saudi production is down nearly 500,000 bpd since October 2016).
In a CNBC interview Al-Falih struck a cautiously optimistic tone, noting that the worst of the downturn was over, and arguing that U.S. shale production in the long-term would not upset the global market. Yet the pace of U.S. production could, he said, have ramifications on price and OPEC would not reduce production to “make room” for U.S. production which went up too high, too fast.
The high compliance rate achieved by OPEC thus far may be something of an illusion, as the bulk of the cuts have come from Kuwait, which cut a lot quite quickly, and Saudi Arabia which cut more than was necessary. This has allowed Iran and Iraq to boost production despite the calls for cuts.
Right now, it’s too soon to tell if OPEC will take additional action or wait for low prices to squeeze it competitors. Al-Falih’s confidence that the worst is over may offer some clue as to Saudi intentions, which include next year’s IPO of Saudi Aramco, its massive energy company with a somewhat suspect price tag. It’s possible that Riyadh along with the rest of OPEC will return to its 2014-2016 strategy of pumping freely in order to pressure out high-cost competition. Yet that strategy cost OPEC billions and netted no real gains. And this week’s correction may prove to be temporary, with prices picking back up and U.S. shale production meeting demand while OPEC recovers production once the cuts end later this year.
Whatever decisions are made after this week’s fireworks, the narrative pitting U.S. shale against the oil fields of the Gulf is unlikely to go away any time soon.
The United States Oil Fund LP ETF (NYSE:USO) was unchanged in premarket trading Monday. Year-to-date, USO has declined -12.20%, versus a 6.33% rise in the benchmark S&P 500 index during the same period.
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