Oil markets seem to have stabilized on the back of reports that the Organization of Petroleum Exporting Countries (OPEC) and non-OPEC producers (read Russia) are trying to get an agreement in place to stabilize markets.
The parties pushing for the meeting – Russia, Venezuela, and Nigeria – are hoping a concrete freeze accord headline can get prices back above $50 a barrel by year end. Indeed, there are bullish signs in the market.
First and foremost, fears that Iran was poised to increase its production by upwards of 500,000 b/d to 1 million b/d once Western sanctions were lifted look unrealizable. Iran’s exports have only increased to 1.4 million b/d, up from 1.1 million b/d, and likely reflect some sales from storage.
Secondly, some of the market oversupply was eased temporarily by disruptions in exports from Nigeria and Kurdistan.
Finally, summer is a time when Saudi export levels get curtailed by internal demand for crude burning for electricity generation. In other words, OPEC-non-OPEC news might have created psychological sentiment but markets are entering a seasonally higher demand period with some non-geopolitical supply redress.
That begs the question whether the OPEC-Non-OPEC freeze is in any way meaningful.
I would argue not in the way the market is discussing it. In 1999, 2003, and 2009 low oil prices stimulated increases in demand and created an environment where a reasonable agreement between OPEC and non-OPEC oil producers could boost prices substantially. A similar agreement is unlikely to unfold in a similar manner for 2016 because oil geopolitics structurally has changed. The oil sector is facing dramatic and transformational structural changes and so has the geopolitical context.
Today’s new world geopolitical order for oil is dominated by just three giant producers – Saudi Arabia, Russia and the United States. The three oil superpowers have combined liquids output about 40% of world demand. The three powers are also locked head to head in the conflict in Syria. Understanding the dynamic of both provides additional insights in market dynamics.
A tentative cease fire agreement has been announced for Syria. On March 14, Russia announced it would start withdrawing “the main part” of Russian armed forces from Syria, having created the necessary conditions for starting the peace process.
In other words, President Putin had established his goal to make clear Russia is an important and vital part of any peace process, having obviated developments last year where the U.S. might have brokered a deal between Saudi Arabia and Iran over Syria without sufficient consideration to Russia’s interests. Round One: Russia scores a point.
But Russia’s geopolitical gain came at a costly price. Its economy has been decimated by low oil and gas prices, and it is unclear if its withdrawal announcement is because, as it stated, it achieved its mission, or if, it is crying uncle to the alleged campaign against it by Saudi Arabia who has been using low oil prices as a key pressure point.
In recent weeks, Kuwait passed an annual 2016 budget citing $25 oil as its base. Saudi royals had similarly made clear in private meetings in January that the kingdom would be willing to see prices fall to $10 a barrel if necessary.
Putin’s withdrawal announcement came just days after Sergei Chemezov, chief executive of major arms firm Rostec said that low oil prices were forcing Russian defense spending cuts, lending credence to the idea that it may be Saudi Arabia and not just Moscow that scored a point in the latest geopolitical round over oil and Syria.
Russia may have the Assad regime back from the brink of collapse but Saudi Arabia has leverage at the peace process bargaining table as well. Moreover, it has space to let the oil market linger for the next few months, not only because its own summer export dynamic but also because the joint U.S.-GCC pre-nuclear accord strategy on Iran – sanctions and low oil prices – has left shuttered Iranian oil fields in such bad shape that a sudden restoration of production and revenues is unlikely for the time being. Point two for Saudi Arabia.
For the United States, President Obama is under fire for what is viewed by many among the American public as a failed strategy in Syria and damage to American power abroad for ceding too much space to Vladimir Putin and Iran. Yet, in oil geopolitical terms, the United States has come out with a win. Low oil prices and other domestic political election year factors converged to force the President to accept a lifting of the decades old oil export ban. This is a big “one point” in the score for the U.S.
Saudi Oil Minister Ali Naimi stated at CERA Week in Houston last month that “Efficient markets will determine where on the cost curve the marginal barrel resides. The producers of these high cost barrels must find a way to lower their costs, borrow cash or liquidate. It sounds harsh, and unfortunately it is, the most efficient way to rebalance markets. Cutting low cost production to subsidize higher cost supplies only delays an inevitable reckoning.”
The minister might be surprised to find that rather than shutting in, U.S. producers will take up his challenge to cut costs and thereby even as prices were nearing $30 a barrel, the United States, to quote a Reuters news report “ is exporting its oil everywhere.” Already this year, U.S. shale break-evens have fallen 30 to 40% while reserve estimates have risen. Similar cost deflation is likely to unfold in deep water development.
To quote a recent article I authored with Edward Morse, “U.S. shale resources are not only super-abundant, but they can be exploited both at a relatively low cost and quickly. This counts a great deal because the costs of entry to the US shale are extremely low and this allows the atomistic, fragmented and competitive U.S. exploration and production sector as well as its financial services sector to both increase supply as prices rally and to be very slow and robust in damping supply at low prices. For example, consider the typical offshore oil well of yester years. Offshore wells cost about $170 million to complete and take 5 to 7 years to first production and an additional five years to payback costs. A shale well, by contrast, can cost under $5 million, with first production coming on line almost instantly to the drilling completion and paying out within five-months. With such a short time frame from the investment decision to first production for shale, U.S. shale production can surge quickly as soon as prices recover again. This is a dramatic difference to 1998 where oil company first production lagged renewed spending in places like offshore Brazil, Africa and Australia for close to a decade.”
In other words, U.S. exports are likely to change the dynamic for global oil markets for the foreseeable future, if not forever. Many of the U.S. cargoes have already wound up in Europe, creating competition for OPEC suppliers and Russia, and giving the U.S. a leg up in discussions about U.S. foreign policy with oil exporting rivals states. Point one for the U.S. Our energy security and those of our allies is not as vulnerable to OPEC or Russian policy as in the past. That fact gives the U.S. more leverage in future negotiations over Syria, should we choose to use it.
In the end, were the United States to stay the course on policies aimed to lower oil demand and to continue to cooperate with China to do the same, Saudi Arabia will have to think twice about trying to return to a revenues oriented strategy. Even if oil markets tighten temporarily this spring, OPEC and non-OPEC producers alike will have to think carefully about the long term loss that might ensue by delaying the development and production of reserves. That’s because doing so might cause them to disadvantage themselves over the longer time horizon.
Minister Naimi made clear in his speech that he believes oil demand will continue to increase in the long term. But he also noted that the Paris climate accords pose a far greater “existential” challenge than cyclical price movements.
To the extent that policy and technology dampen the upward trajectory of oil use, as it has already done in the OECD and is likely to do in China, proven reserves could suddenly become depreciating, rather than appreciating, assets. For Saudi Arabia and Russia who each have between 50 to 100 years of reserves, the prospect that some producers could be left in a decade or two with unmonetizable resources – potentially stranded assets just like thermal coal – ultimately dictates against sustained cartel behavior.
As the minister noted, market rebalancing would argue against Saudi Arabia in effect preserving the short term market for higher cost producers such as Canadian oil sands or Brazilian deep water at the expense of his country’s largest financial asset – oil under the ground.