OPEC and $80 oil: last week’s meeting

$80 per barrel oil

Over the past year the price of a barrel of crude oil has risen from $50 to $80.  The latter figure is substantially below the $100+ that “black gold” averaged during 2011-2014, but hugely higher than the low of $25-minus thee years ago.

conventional wisdom upended

Two pieces of conventional wisdom about oil have changed during the past half-decade:

–effective shale oil production technology has shelved the previous, nearly religious, belief in the near-term peaking of world oil productive capacity.  More than that,

–the development of viable electric cars has won the world over to the idea that a substantial amount of future transportation demand is going to be met by non-petroleum vehicles.

new meaning for “peak oil”

The “peak oil” worry used to be about the day when demand would outstrip supply (as emerging economies switch from bicycles/motorcycles to several cars per household–just as conventional oil deposits would begin to give up the ghost).  The term now means the day (in 2040?) when demand hits a permanent peak, and then begins to fall as renewable energy supplants fossil fuels.

new OPEC solidarity

When Saudi Arabia, the most influential member of OPEC, said during the recent supply glut that its target for the oil price was $80 a barrel, I thought the figure was much too high.  Why?  I expected that the cartel wouldn’t stick to mutually-agreed output restrictions (totaling 1.8 million daily barrels) for the years needed for oversupply to dry up and the price of output to rise.  That was wrong.

I think the main reason for OPEC’s uncharacteristic sticktoitiveness (first time I ever typed that word) is the realization that petroleum is going to yield to renewables as firewood was supplanted by coal in the mid-nineteenth century and coal was replaced by oil in the mid-twentieth.

There are other factors, though.  The collapse of the Venezuelan government means that country now produces about a million barrels a day less than two years ago.  Also, Mr. Trump’s aversion to all things Obama has prompted him to pull the US out of the Iranian nuclear agreement and reinstate an embargo.  This likely means some fall in Iranian output from its current 4.5 million or so daily barrels, as sanctions go back into effect.  Anticipation of this last has upped today’s oil price by something like $10 a barrel.

adding 600,000 barrels to OPEC daily output

Just prior to the Trump decision on Iran, Russia and Saudi Arabia were suggesting publicly that the coalition of oil producers eventually restore as much as 1.5 million barrels of daily production, as a way of keeping prices from rising further.  Mr. Trump has reportedly asked the two to make any current increase large enough to offset the $10 rise his Iran action has sparked.

Unsurprisingly, his plea appears to have fallen on deaf ears.  Last Friday the cartel announced plans to put 600,000 barrels of daily output back on the market–subject, I think, to the condition that the amount will be adjusted, up or down, so that the price remains in the $75 – $80 range.

optimizing revenue

The old OPEC dynamic was Saudi Arabia, which had perhaps a century’s worth of oil reserves and therefore wanted to keep prices steady and low vs. everyone else, whose reserve life was much shorter and who wanted the highest possible current price, even if that hastened consumers’ move to alternatives.

Today’s dynamic is different, chiefly because the Saudis now realize that the age of renewable energy is imminent.  Today all parties want the highest possible current price, provided it is not so high that it accelerates the trend to renewables.  The consensus belief is that the tipping point is around $100 a barrel.  $80 seems to give enough safety margin that it has become the Saudi target.

 

 

 

 

 

 

oil at $50 a barrel

It has been a wild ride.

Crude began to run up in early 2007.  It went from $50 a barrel to a peak of around $150 in mid-2008.  Recession caused the price to plunge to $30 a barrel late that year.  From there it began a second, slower climb that saw it break back above $100 in early 2011. Crude meandered between $100 and $125 until mid-2014, when increasing shale oil production from the US caused supply to outstrip demand by about 1% – 2% a year.  That was enough to cause a second slide, again to $30, that appears to have ended this February.

Since then, the price has rebounded to $50 a barrel, where it sits now.

To recap:  $50, then $150, then $30, then $125, then $30, now $50.

Where to from here?

We know that supply remains relatively steady, with additions to output from the Middle East offsetting falls in US shale oil liftings caused by lower prices.  We also know that lower prices have stimulated consumption.

The past eight years have also shown us that crude can have exaggerated reactions to small shifts in supply and/or demand.  So, in one sense, no knows what the crude oil market will do next.

On the other hand, we can set some parameters.

–the first is psychological.  The oil price has fallen to $30 a barrel twice in the last eight years.  The first was in the depths of the worst recession since the Great Depression.  The second was during a period of general market craziness earlier this year (caused, I think, by algorithms run amok).  I think it’s a reasonable assumption that prices will have a difficult time getting that low again–and if they do that they won’t stay there for long.

–the second is physical, and is about shale oil.  Overall shale oil output in the US is now shrinking.  Firms still pumping out shale oil are of two types:  companies being forced by their banks to sell oil to repay loans; and companies whose costs are low enough that they’re making a reasonable profit at today’s prices.  Cash flow from the first group is by and large going to creditors, so this output will diminish as existing wells are tapped out.  That’s probably happening right now, since shale oil wells typically have very short lives. This means, I think, the question about when new supply comes to market–putting a cap on prices, and perhaps causing them to weaken–comes down to when healthy shale oil firms will uncap existing, non-producing wells, and/or begin to drill new ones in large enough amounts to reverse the current output shrinkage.

I’m guessing–and that’s all it is, a guess–the magic number is $60 a barrel.

My personal conclusion, therefore, is that the crude price may still have a gentle upward bias, but that most of the bounce up from $30 is behind us.

 

 

 

the influence of speculators in the crude oil market

The conventional view taught in business schools is that speculation is good.

Boiled down to its essentials, the argument supporting this view is a very simple one:  suppose there were no one to take the other side of the trade of, say, a farmer seeking to guarantee a minimum price for his corn crop that would ensure he’d cover his costs and have something left over to keep body and soul together.  There may not be enough cereal makers or animal feed producers who want to hedge their costs in the same amounts and at the same time as the farmer.  If not, who’s left to be the buyer of the commodity contracts the farmer wants to sell?  The answer:  speculators, who have purely financial motives and who will step in to stabilize a market by buying and selling commodity futures contracts before prices get too wacky.

In this picture, the main players are the producers and users of commodities; speculators play a minor role, though a convenient one for the theory.

 

I don’t know whether this was a solid description of the way commodities markets worked a generation or two ago,  or just a product of the many simplifications of the real world that academics need in order to have their mathematical models work more smoothly.  But even if they once were correct, do these ideas still work in a world where prop trading, hedge funds and commodity-based ETFs abound, and where brokers have made it much easier for ordinary investors to buy commodities futures directly?

the case of crude oil

In 2008, after an oil price spike that saw the price of crude nearly double from a starting point of $80, the Commodity Futures Trading Commission issued a report, based on the traditional thinking, which found that speculation played little role in the upward move.  The Baker Institute of Rice University is the most well-known of observers who criticized the CTFC findings.  It said the commission had ignored its own data, which showed a dramatic rise in the involvement of the proprietary trading desks of investment banks, of hedge funds, and of commodity funds in oil trading.  On the Baker Institute’s reckoning, these speculative entities made up half of the market (and they all wanted to bet that oil price would rise).

Apparently in response to this criticism, on July 5th,the CFTC published a relatively large set of data showing the relative importance of hedgers and speculators in various commodities markets, including crude oil.  What called my attention to the report was an article in the Financial Times that says speculators make up a majority of the trading in metals, agricultural and financial futures–but in crude oil, they comprise well over 90% of the trading volume!!  (I’ve cast my (unpracticed) eye over the figures.  I don’t see the 94.5% speculation the FT reports, but most categories of crude show hedgers make up less than 20% of the market.  Same difference.)

my thoughts

The CFTC is proposing that the government limit the number of positions a speculator can hold as a way of limiting their influence.  And the International Energy Agency has already organized a limited release of some of the crude oil stocks held by oil-consuming nations in an effort to cause speculators to liquidate.

CTFC action would just make speculators relocate, however.  The IEA has a worry, too –that speculators have deeper pockets than it does.  Both agencies are treating symptoms, not the root cause, of high oil prices.

In a lot of ways, the current oil situation reminds me of froeign exchange during the Bretton Woods era of fixed currency rates.  During Bretton Woods, countries periodically tried to defend a certain currency level, even though that level was ultimately being undermined by structural economic problems that at least one of the countries involved refused to address.  The banks speculating against the currency exchange rate were, in effect, betting that the structurally weak country didn’t have the political will to make needed changes.  Generally speaking, the banks were right.  They thought it was like shooting fish in a barrel.  Ultimately, the Bretton Woods arrangement collapsed.

The structural issue for petroleum in today’s world is the failure of Washington for more than a third of a century to fashion an effective energy policy that reduces the country’s dependence on crude oil.  In part, this has been a way of protecting a politically powerful but badly run domestic car industry–which is even now lobbying hard against proposed increases in fuel efficiency standards for cars and trucks that would bring the US into line with the rest of the developed world in ten years or so.

The massive speculative bet is that the current situation won’t change much–resulting in higher oil, a lower US dollar and slower economic growth in the US than would otherwise be the case.

investment implications

The straightforward bet on this issue would be for or against the stocks of oil producing companies.  Slow growth domestically and a weaker US$ would also favor US-listed companies with significant operations outside the US, however.  For anyone, like me, in the weak-$, slow-growth US camp, I think the latter group of stocks will do relatively well under most oil price scenarios, making them the better way to go.