Oil’s Mixed Signals

Oil prices stabilized last week amid reports that the US rig count has fallen close to 25 percent from its peak in October 2014. Yet even with some positive news about oil demand trends in December, analysts are assessing the surplus in oil markets for the first quarter of 2015 to be 2.5 million b/d to 3 million b/d, hardly fundamentals on which to place a rally. And, traders and countries like Saudi Arabia are holding massive stocks afloat in oil tankers at sea. The increasing oil at sea comes atop reports that several weeks of builds in stocks at the key Cushing Oklahoma onshore storage where some analysts expect demand for storage to outpace capacity by spring.

Citi threw even more cold water on this week’s rally by noting that the horizontal rig count in the Bakken, Eagle Ford and Permian tight oil plays has only fallen by 9%, meaning that US oil production could still easily rise by 500,000 barrels a day (b/d) to 900,000 b/d this year, despite low prices.  These three US regions, which contributed to over 80 percent of the gains in US production last year, were expected to provide upwards of 90 percent of the gains forecast by the US Energy Information Administration (EIA) and others for 2015 and beyond. The fact that few rigs have been laid down there is material to prognostications of doom in the US oil patch. The Permian output was targeted to ratchet up sharply this year and next, replacing less robust areas. For top US producers with improved fracking gels and processes, productivity gains on average of 20 to 25 percent are starting to get baked into positive output forecasts that will likely defy the price drop. Shale also offers the peculiar opportunity that firms can return to already completed production sites and “re-frack” using improved technologies, and the market still has an overhang of wells that were drilled, but not completed. In other words, any temporary improvement in prices can quickly produce recovering production, a reality well understood in US natural gas markets.

However, this week’s price rally also portends another feature of oil markets: geopolitical and other kinds of above ground Black Swan risks have not disappeared and have the potential to resurface quickly. Confirmation in the New York Times that geopolitical forces related to Syria are driving Saudi oil policy leaves open the possibility – perhaps currently remote— that Saudi Arabia and Russia could make more substantial progress on Syrian peace talks. Syrian leader Bashir al-Assad was recently characterized as “delusional” on the subject of his country’s civil war and shows no signs of willingness to step down or even change strategies.

Moreover, markets seem to have completely sluffed off reports that the Islamic State (ISIS) temporarily gained control of Iraq North Oil Company’s 35,000 b/d Khabbaz oil field near Kirkuk.

Kirkuk is an important oil production region for Iraq and its political status has been highly contested. The Kirkuk oil fields came under the control of the KRG military in July 2014, but the region’s territorial status remains contested by both Baghdad and local Arab and Turkoman leaders. The fields around Kirkuk are producing 400,000 to 500,000 b/d currently and could contribute to a large increase in the country’s future oil production. At present, under a tenuous deal between the Kurdish Regional Government (KRG) and Baghdad, oil exports of 550,000 b/d by pipeline to Turkey are to be shared 45 percent/55 percent respectively.

ISIS continued strategy to try to grab oil fields for its possible “statehood” underscores a grave danger for the region and a source of instability to global oil supply. If existing national borders and authorities are not considered permanent or authoritative, regional oil facilities will become both strategic assets and spoils of war in not only the greater battle for Syria and Iraq but potentially in the struggle for geopolitical power across the entire region. This turn of events is a serious challenge to stability across the Middle East and for the global oil market. My research with econometrician Mahmoud El-Gamal shows that oil facilities damaged during wartime can dramatically reduce access to oil from a country for years, if not decades.

The concern that oil will drive military actions across the Middle East cannot be overstated. IS, led by former military leaders from Saddam Hussein’s brutal regime, clearly understand the importance of oil assets and revenues during wartime, given their history of Iraq’s 8 year war with Iran and battle for Kuwait. The ISIS “oil related” threat in the region, while mainly ignored by oil traders, has not been lost on other regional powers. Troops are already lining the Saudi northern border, where a wall is being constructed, and Iran has positioned troops to protect Iraq’s southern oil fields at a time when Basrah’s local leaders have been threatening to hold a referendum on whether to become a semi-autonomous region like the KRG.  So as oil accumulates and overhangs the market in floating storage and onshore at Cushing – bringing with it huge downside risks- military facts on the ground in Iraq speak otherwise. It’s no wonder then that oil prices appear stuck for the moment – til the next shoe drops..