No respite in sight for the oil price

STEPHEN BARTHOLOMEUSZ
15 MAR, 2016
Spectator

Last week the International Energy Agency speculated that oil prices might have bottomed. Yesterday OPEC said its output fell in February. Yet the oil price slipped back below $US40 a barrel overnight.
A large part of the explanation for why the price had risen more than 40 per cent from its January low of $US27.82 a barrel was the prospect of an agreement between OPEC and the big non-OPEC producers to freeze their output. That possibility was raised by an agreement announced by Saudi Arabia, Russia, Qatar and Venezuela in February.
Their “offer”, however, was rather cynical and came with a very large asterisk. In a market where supply already outstrips demand by about two million barrels a day and where global inventories are at record levels they were offering to freeze their output at January’s record levels.
Moreover — and here’s the asterisk — the “offer” was conditional on Iran also agreeing to cap its production at January’s level. Given that Iran is only just starting to restore production severely impacted by sanctions that were finally lifted in January, that was a deal Iran would never agree to.
Where the IEA saw potential “light at the end of a long, dark tunnel” for the oil price, Iran sees itself adding another million barrels a day to the market to boost its output back to the four million barrels a day it was producing pre-sanctions.
“They should leave us alone” until production was back to pre-sanction levels, the Iranian oil minister is reported to have said yesterday.
“After that we will work with them,” he said.
While the initial target of the Saudi-led strategy that has collapsed the oil price was the US shale oil sector, which had transformed the dynamics of the global sector and the geopolitical settings by giving the US energy self-sufficiency, the Saudis would also have been keeping an increasingly close and concerned eye on regional archrival Iran.
If the strategy included an attempt to try to limit the amounts of revenue Iran gained access to after the sanctions were lifted by including it in a supply-constraining agreement with the bother major producers, it would appear to have failed at the outset.
It should be said that, while the IEA was relatively optimistic in last week’s assessment of the market’s outlook, that optimism wasn’t wild. It still expected supply to remain ahead of demand until 2017. Its more positive view, however, was based on its expectation of a larger than previously expected decline in US shale oil production.
OPEC’s latest report, issued overnight, sees slightly softer demand growth this year than it had previously forecast and said it expected non-OPEC producers were cutting supply more than it had previously expected. It expressed uncertainty, however, about the 2016 supply outlook.
The US shale oil sector has consistently defied expectations that the plunge in oil price would decimate its production. While drilling activity has been reduced dramatically, production hasn’t fallen in line.
That’s partly because some of the most marginal producers have kept producing rather than exiting the industry, partly because a lot of the smaller producers had hedges in place and partly because the sector has continually improved its productivity and reduced its costs.
The sharp spike in the price over the past month would, if sustained, relieve some of the pressure on the producers and make it easier to hedge this year’s revenues, helping to sustain US supply.
The oil price action over the past month and a half has occurred despite US oil inventories being at their highest levels in more than 80 years. Historically there has been an inverse correlation between US inventory levels and oil prices.
A slight weakening of the US dollar against a trade-weighted index of its major trading partners over the past eight weeks might, conversely, have supported the oil price rise. The oil price (denominated, of course, in US dollars) and the US dollar have also demonstrated a clear inverse correlation in the past.
If the US Federal Reserve Board were to express a bias towards continuing to raise US official interest rates this year at its meeting this week, of course, the dollar could strengthen again and the oil price could fall back further.
At some point the impact of the dramatic cuts to investment in future production and, inevitably, the eventual withdrawal of uneconomic capacity, ought to have an impact on the price in a market where the annual depletion of reserves amounts of four or five million barrels of production a day.
That point — and an oil price closer to $US70 a barrel than $US40 a barrel — appears to be pushing further into the future, however, as global production continues to outstrip demand and Iran’s rising output impacts an already unbalanced supply-demand equation.
For the Australian companies with leveraged exposures to oil prices — like Santos, Origin Energy, Woodside and BHP — there is no option but to hope for stronger prices, or at least stability around the $US40 a barrel level, while planning for the possibility of them falling back towards $US30 a barrel or lower.