Oil markets: a turbulent 2016, an uncertain 2017

After two and a half years of opening up the taps (or rather: not closing them) OPEC has changed course in what is looking to be a gamechanger for the oil market. Market sentiment has shifted and the oil price has gone up by some 20 %. We can look back at a turbulent 2016 and look forward to an uncertain 2017.

OPEC defeated?

Some say OPEC’s decision to cut was a defeat. Was it really? OPEC (and most of all: Saudi Arabia) over the last two years has been trying to deal as good as possible with the difficult situation that the 2009-2014 high oil price world had created for them.

Would they, from 2014 onwards, have defended price instead of market share US tight oil production would have risen by about 2 mb/d by now (instead of the reduction of about 1 mb/d that actually materialised). The decline from non-OPEC conventional fields would have been 3 mb/d (instead of the 6 mb/d that materialised). For Saudi Arabia it would have been a repeat of the early 1980’s when they did defend price, resulting in a reduction of their production to a level as low as 2.5 mb/d before they gave up.

Two years of defending market share instead of price has resulted in a non-OPEC supply 6 mb/d lower compared to what it would have been otherwise. The large investment cuts in non-OPEC oil will reduce non-OPEC supply for years to come. That is major progress for OPEC. It has brought supply and demand close to equilibrium in 2017. Now a cut became a realistic option in order to bring higher oil prices forward. A 2014 cut would only have postponed the inevitable and increased the length of the subsequent painfull rebalancing period.

They will be disappointed by the resilience of US tight oil. US tight oil has been saved by drilling in the very best spots only, increased efficiencies and reduced service industry costs. Furthermore it has been saved by their investors and financiers – for whom accepting severe losses was a better alternative than to let them go bankrupt and cease operations.

OPEC has regained market share and, more importantly, some of their ability to move markets. US tight oil has survived with break even costs in the very best areas that are now at the lower end of the global non-OPEC cost curve. They have both paid a heavy price. But it is high cost non-OPEC conventional oil that has lost the most in this battle.

Why cut now?

First and foremost, markets have done their work and supply and demand have been approaching a balance, enabling a meaningful cut.

Budget deficits have troubled all producers. A country like Venezuela has been desperate for a deal. Unfortunately for Venezuela it has no clout whatsoever in OPEC. The defining push for the agreement has been given by Mohammed bin Salman (Saudi Arabia’s de facto ruler) and Vladimir Putin. The situation within their countries is such that both have good reasons to do so. MbS is aiming to solidify his grip on power. For that he needs to limit hardship for the Saudi middle class and provide hope for the rapidly growing (and increasingly unemployed) number of young Saudis. Saudi Aramco’s planned IPO will benefit from higher oil prices. Putin as well wants to limit hardship for the Russian population. He can not be as indifferent to the wellbeing of the Russian population as Stalin once was; his grip on power is more secure if he keeps the Russian middle class happy.

Saudi Arabia needed to see pledges from other producers (Iran and Russia in particular) to go ahead. These other producers needed to have confidence that limited cuts will give a substantial increase of the oil price – something that the initial market reaction in September upon the Algiers talks provided to them. Reaching a Vienna agreement became a must; not reaching it would have implied a substantial price drop, something they could ill afford.

OPEC spare capacity is at its lowest level since 2008. Iran is back at its pre sanction level of production and cannot raise production any further in the short term. Russian production is at a record level. Even if producers do not fully live up to their pledges, their ability to cheat and take away market share from Saudi Arabia has become limited. Saudi Arabia can be satisfied that cuts are shared. Iran and Russia can be satisfied as well; their pledges are not a great hardship for them.

What has changed?

Saudi Arabia has lost clout within OPEC. Iraq and especially Iran are challenging its dominant position. Their combined production starts to approach that of Saudi Arabia. Both have large undeveloped oil reserves, which can be developed at low cost, and are still producing way below their potential. In the long run they are likely to further ramp up production. After having been sidelined for a long time due to wars and sanctions both are now reclaiming their natural position in the OPEC pecking order. In the long term, reaching an agreement within OPEC will not become any easier.

Iran in particular by now seems in a better position to overcome periods of low oil prices than Saudi Arabia. Its economy, hardened by years of sanctions, is better equipped to do so and is less reliant on oil income. Saudi Arabia’s pivotal role in OPEC was based on its being the largest producer by far, its maintaining a substantial spare capacity and its large financial reserves that (in combination with a relatively small population) enabled it to better sit out a prolonged period of low oil prices. Some elements of this dominance are now starting to fall away and Saudi Arabia is no longer the sole pivotal nation within OPEC that it used to be.

Oil has always been linked to politics. Saudi Arabia has lost political clout in the Middle East. They are struggling to deal with a Shia encirclement. Their economy is solely dependent on oil and and is not performing well in comparison with countries like Dubai. The religious establishment is a blocker when it comes to reforming education and increasing the role of women in the economy. Their special relationship with the USA is deteriorating now that the USA is moving towards energy independence and more reluctant to prop up fundamentalist regimes. In the meantime Russia has gained influence, by intervening in Syria and by playing a key role in brokering the recent OPEC agreement.

For a long time Saudi Arabia has been a source of stability in the region and Iran a source of instability. That is changing now.

Where do oil prices go from here?

All ingredients seem to be in place to keep oil prices in 2017 at a systematically higher level than in 2016. Compliance will vary among the different producers. But the over 700,000 b/d cut from Saudi Arabia and other members of the GCC (Kuwait and the UAE) in itself is sufficient to bring supply and demand approximately into balance. Even if the level of compliance of other producers is as low as 50 %, the cuts will still lead to a meaningfull reduction of oil inventories.

As oil producers see that the deal delivers the promised rise in oil prices, they will be less likely to cheat – at least initially. The pledged, gradual cut from Russia involves little more than natural decline and a reduction or freeze of short term projects. Russian oil production has been maximised as much as possible over the last few months in 2016, to a level that may be difficult to sustain anyway in the first half of 2017.

Volatility will be there to stay as stories of cheating, outages and potential production increases from uncapped Nigeria and Libya abound. Notes to refiners about shipment reductions will be duly leaked to the media (something that has already started). But throughout the year we will be seeing a return to oil prices that are closer to the long term sustainable price of oil: that of the marginal non-OPEC barrel, somewhere near $ 60 – 80 per barrel.

And let us put things into perspective. The oversupply frequently described as a glut was no larger than about 2 % of global production, at its worst. OECD oil inventories have hovered around 65 days of supply in 2016; little more than 5 days above the long term average. It does not take that much oversupply to send oil prices plummeting. In the same way, it does not take that much undersupply to send them through the roof. One should not blame analysts too much for not being able to predict the oil price. But a bit of blame for underestimating uncertainties might be justified.

How will US tight oil react?

A main source of uncertainty is how US tight oil will react to higher prices. Tight oil’s shorter cycle time and a faster reaction to changes in oil price compared to conventional oil may keep a lid on oil prices. But to what extent?

If we compare a recent global cost curve of oil projects with a 2014 cost curve there are two developments that stand out. Firstly, the average breakeven cost has decreased substantially, from about $70 per barrel in 2014 to about $50 per barrel today. Secondly, over the last two years US tight oil has seen the biggest cost decreases and it has shifted towards the left (more competitive) side of the global cost curve.

For those US tight oil companies that have survived and that have quality acreage there now seems to be a great promise for the future: break even prices near the lower end of the global spectrum of opportunities and huge in place volumes. This is the background for the recent outperformance of share prices for companies active in the Permian (the US region with the lowest break even prices). Break even prices for the very best areas have dropped to about $30 – $40 per barrel. As a whole the US tight oil industry is estimated to need about $55 – $60 per barrel to maintain a flat production level.

There is one snag: break even prices quoted above are for current cost levels of the service industry, widely seen as being unsustainably low. How much will these costs increase once that activities pick up in earnest? Rystad Energy estimated that for the Bakken about 40 % of cost savings were structural (faster drilling, better well production) and about 60 % of cost savings were cyclical (primarily lower service industry costs, to a lesser extent drilling in the very best sweet spots only). When activities pick up significantly, break even costs are expected to increase by about 65 %. Current break even costs for the very best sweet spot areas would be expected to increase from $ 30 to $ 50 per barrel. Non core areas (that currently see little activity) could see an increase from $ 50 to $ 75 per barrel. Other studies have reached similar conclusions.

Quoting from a recent SPE panel discussion: “If oil prices stay below USD 55/bbl, equipment availability can be relatively smoothly managed in the Permian. But at prices from USD 60/bbl to 70/bbl all of a sudden all of the other plays come back, and then for sure we reach the threshold of equipment not being available”.

I feel that many analysts overestimate the ability of US tight oil to act as a swing producer. Firstly, things take time. Hiring drilling crews to man the often less efficient rigs that have now been cold stacked takes time. Hiring fraccing crews takes time. Getting permits takes time. It took two years before the effect of low oil prices on US tight oil production had materialised in full. Secondly, costs of drilling and fraccing follow the oil price. US tight oil will indeed keep a lid on oil prices. But to a smaller extent than what is often assumed.

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