T he end of the Organization of Petroleum Exporting Countries (OPEC) has always been greatly exaggerated. For the past forty years, Western policymakers and scholars have focused on predicting the demise of OPEC while ignoring the more urgent question of where the world’s economic interests are really rooted — in a dismantled OPEC or in suitable structural adjustments.
Ever since the invention of the internal combustion engine, oil has enjoyed a near monopoly at the top of the commodities food chain as a crucial energy source and a key driver behind the growth of the transportation economy. Today, the oil market is bigger than all raw metal commodity markets combined. The Energy Information Administration (EIA) forecasts global oil demand to average approximately 98 million barrels a day in 2017 and to surpass a key milestone of 100 million barrels a day during the second half of 2018.
At current prices, this puts the demand side value of the oil market at around $1.8 trillion per year — almost three times larger than the revenues generated from all major raw metals and minerals combined. Still, the positives are in short supply for beleaguered oil prices and “breaking the cartel” isn’t going to change that.
The supply-driven oil glut and its impact on OPEC policies is here to stay and so are the risks of deflationary economic turmoil and crippling volatility in energy prices. In fact, crude oil prices are already close to where they were trading before OPEC and non-member nations agreed to cut production last November — despite a near-perfect compliance in delivering its pledged 1.2 million barrels a day production cut (Side note: Compliance has since weakened to around 89 percent of pledged reductions from a record 104 percent).
OPEC will continue to raise prices in the short-term through an output cut extension at this week’s meeting, but it will only be so long before U.S. light tight oil (LTO) producers start to claim market share conceded by OPEC in a higher price environment.
The Permian basin is already producing 2.2 million barrels a day, double that of 2011, and the EIA forecasts record U.S. crude oil production of 9.9 million barrels a day for 2018. Moreover, the average wellhead breakeven price in the Permian’s Midland sub-basin has experienced a significant drop, falling by 33 percent year-over-year on average from 2014 to 2016. The most competitive wells currently exhibit breakeven prices between 25 and 30 USD/bbl.
This is an existential problem for OPEC. The success and unity of any functional cartel depends on its ability to hold its members by fulfilling its objective of higher prices. In the case of OPEC, its members require oil prices to stay at or above 60 USD/bbl to stabilize their economies and fiscal deficits. Current outlook suggests that the majority of major oil-producing nations are destined for some lean and hard years ahead.
Source: Bloomberg, Joint Organisations Data Initiative (Note: Net export cut includes exports of crude plus net exports of refined products. Both series reflect change from October 2016 baseline. Export data for April is not yet available.)
While the International Energy Agency (IEA) still predicts a rapid reduction in the supply glut in the second half of this year if OPEC maintains its cuts, available data show few signs of success. Whatever happens on May 25 in Vienna, the long-term fix for an oil price recovery will remain grim.
Most petrostates recognize that although 50+ USD/bbl crude oil has been enough to resurrect the U.S. LTO industry, there is another group of U.S. suppliers waiting to increase production should the West Texas Intermediate (WTI) benchmark manage to rise above 60 USD/bbl: Offshore Exploration & Production companies.
In a world where potential oil reserves and supply outpace demand, what seems likely to happen is low-cost producers steadily increasing output and higher-cost producers getting gradually crowded out. Since the majority of the lowest-cost resources sit in large, conventional onshore oilfields, particularly in the Middle East and Russia, higher-cost producers have to maximize output as long as the financials still work in their favor. This would also explain the aggressive shale resurgence and why the 11 non-members joining OPEC’s effort have only implemented about two-thirds of their promised reduction so far, according to data by the IEA.
British Petroleum pegs the cumulative oil demand until 2035 at around 700 billion barrels, which is significantly less than the recoverable oil in the Middle East alone. In its current Energy Outlook 2017, the British multinational oil and gas company estimates that known oil reserves dwarf the world’s likely consumption of oil out to 2050 and beyond.
What OPEC faces is not merely a loss of faith in its ability to rebalance the oil market, but the early onset of fatigue in economic activity and demand. In January, U.S. gasoline consumption fell to as low as 8.2 million barrels a day, nearly matching a 15-year low. February’s data showed that U.S. gasoline storage levels reached their highest level since the EIA began tracking the data back in 1990.
U.S. crude exports hit their second highest level since the 40-year export ban was eased as U.S. refinery volumes have climbed to 17.3 million barrels a day — the highest in data that goes back 35 years. The supply glut is simply being exported and transferred from crude to refined products while imports from Middle East OPEC countries shows no sign of falling.
In the short-term, this may help mask the symptoms of the oil glut, but shifting excess supply downstream and overseas is not a workable long-term solution as it fails to address the underlying problem.
If OPEC’s members were focused on addressing the oil glut head-on, they would let prices retrace to a level that triggers a washout of excess supply from high-cost producers by leveraging their low operating costs per barrel. This would not only boost demand but also help preserve OPEC’s market share. Indeed, this was OPEC’s strategy from 2014 to late 2016, culminating in the realization that a significant number of higher-cost producers are in many ways now more competitive than most OPEC producers.
Source: EIA, Bloomberg (Note: 4-week moving average of imports from Saudi Arabia, Iraq and Kuwait)
Even if OPEC were to succeed in pushing up prices with extended supply cuts, higher-cost producers will lay on new hedges for 2018 and pull prices back down by redeploying their cash flow to produce more oil. It is our belief that cheaper oil is here to stay and that prices will resume a descend to the low 20s USD/bbl resulting in a severe washout, and that 58 USD/bbl will act as a firm price ceiling rather than a soft floor going forward. If LTO producers can live with oil at around 50 USD/bbl, then others will have to adapt themselves to that lower level.
The problem for many petrostates is, while they have access to cheap oil in an operating sense, their competitive advantage is quickly drained away by the need to fund massive budget deficits and public sector expenses through oil revenues in a lower-price environment. In the case of Saudi Arabia, we believe Saudi Aramco may opt to raise $15 to $20 billion via bond issuance rather than try to hold out for the company’s initial public offering.
Without an additional 1.2 million barrels a day in production cuts there is little hope of draining excess inventories and propping up prices in the short-term. It is also worth noting that Iran appears to have the potential to increase oil production by 3 million barrels a day. This increase would be in addition to the 3.76 million barrels a day the country is currently producing in the absence of any new sanctions targeting its oil exports.
Oil companies are not only overproducing but also over-exploring. Oil executives have been conditioned to invest in new reserves as economic growth has always generated significant oil demand in the past. Despite a shift in future outlook, the reserves on the balance sheets of oil companies still account for a significant share of their market valuation. Put another way, investors continue to value oil companies based on backward-looking metrics.
This poses a significant risk for oil companies, and investors. Once oil companies start to scale back their investments in new exploration and development projects, it will signal to the market that new reserves have limited economic utility and thus will lead to a severe re-rating in asset pricing that will have a significant impact on the market value of oil companies.
In an energy market that is changing in fundamental ways, seasoned market participants understand that muddling through the oil glut until a supply crunch emerges is no longer a bonus but a necessity. If OPEC production cuts are the only strategy, holding back the eventual supply tide will be as likely as the discovery of oil in Vienna.
Disclosure: WSD Capital Management and certain funds and accounts it manages currently maintain investment positions that are expected to profit if the price of oil declines.