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There is certainly no shortage of theories in the world of finance about what is happening in the oil market. While cases can be made for oil to rapidly trade back up to the lofty $110 a barrel mark, equally convincing and rational cases can be made for oil to trade back below $30 a barrel.
Reading the oil market is difficult and trying to understand all the various factors at play can be confusing. This article is then no different to so many others as it will offer yet another theory about what is truly happening in the oil market. Whether or not that theory is correct, only time will tell.
Let’s start with what everybody knows already. Oil prices had declined by some 70% from August 2014 to February 2016, the worst price crash in a decade, on the back of slowing global demand and an ever-increasing supply of oil to the market.
Shale producers were popping up everywhere while green energy was starting to gain traction. The world seemed to be moving on from pumping out crude oil in order to fuel the global economy.
A brave new world was being created by everyday people who would no longer be dependent on liquefied dinosaurs in order to fuel their cars.
The price of petrol was coming down, so those people who were not completely sold on the idea of a green world without oil were also smiling as their gas-guzzling pollution machines cost less and less to run. Good times.
It may have been good times for consumers, but producers paid the price. Smaller oil producers, such as the shale producers in the US, were coming under a lot of pressure as the lower price of oil was making their operations unsustainable.
Rigs started shutting down, yet the oil price kept falling. On a year-on-year basis, the active rig count in the US has fallen by 471 rigs to 404. This is a decline of over 50%.
US oil production in March was down about ?500 000 barrels a day from its April 2015 peak, according to the US Energy Information Administration (EIA).
Canada has seen a similar percentage change, with that country’s rig count falling by 55 to only 43 active rigs as at the last count on 27 May by oil field services company Baker Hughes.
Focusing on the bigger of the two producers in this part of the world – the US – we need to look a little further back than just 12 months in order to see the real impact that the falling oil price has had.
In August 2014, when the price of oil started its epic decline from $105 a barrel, there were a total of 1 931 actively drilling oil rigs in the US alone. On 27 May 2016, that number has fallen to 404, a 79% decline – all due to the falling oil price.
Graph 1 to the right indicates the utter devastation that has taken place amongst oil rigs in the US.
As can be seen in Graph 2, the US isn’t the only victim. Most notably the European and Asia Pacific regions have been feeling heat as well. European rig counts are down from 143 in August 2014 to 90 in April 2016, a 37% decline.
Asia Pacific rig counts are down from 255 in August 2014 to 179
in April 2016, a 29% decline. This is while the rig count in the Middle East is
little changed at 384 in April 2016, down 5.4% from 406 in August 2016. And
even so, the Saudis are managing to produce more oil than ever before.
Price rally
Now the first thing you’d ask is: “But from the end of February until now the oil price has rallied substantially… Why are oil rig counts falling when the price of oil is on the up again?”, and this is a good question.
There are two reasons for this, I think. The first being that smaller oil-producing operations (companies) are literally going out of business and shutting down, and the second is that the rigs that remain active are significantly more efficient than the ones that are being shut down.
Another reason that could perhaps have had an influence here is that the supply-side constraints, which we have seen coming in thus far this year, are all of a temporary nature.
Fires in Canada, the Niger Delta Avengers (a rebel group in Nigeria) blowing up Chevron’s oil wells in Nigeria, among other random supply-side shocks, are not exactly the types of events that are going to keep the Organization of the Petroleum Exporting Countries (Opec) from relentlessly increasing its production. And it has been doing just that so far.
Now here is where we get to the theoretical part, mixed with a touch of conspiracy theory. Opec – and its most powerful member, Saudi Arabia – has been steadily increasing the amount of crude oil it produces, even when oil prices were rapidly falling.
The country has also not been shutting down nearly as many rigs as the rest of the world has in order to curtail production. If you look at the rig counts, you’ll see that it has instead maintained its rig numbers.
Let’s ignore Opec member Iran, which currently exports around 2m barrels per day with the aim of increasing output to 3.8m barrels a day as it enters the ongoing fray for market share. Iran is trying to get oil production back up to and beyond what it was before it was sanctioned out of the picture.
Now that sanctions have been lifted, the country wants to reclaim its place as a major oil producer and of course turn around (rescue) its economy. I think that is fair enough and its efforts are also small enough not to really matter in the bigger picture.
Saudi Arabia’s competitors, however, are seriously feeling the pressure and are being forced to shut down rigs and stop production as the price of oil is too low for them to be profitable. In some cases, as is the case of Russia, it has tipped economies into recession.
This matters very little though to those who stand to profit from the Russians’ losses. Another interesting side note here is that the Abu Dhabi Sovereign Fund, which is essentially the pension fund for Saudis, was buying large numbers of Sasol shares when it was trading at around the R400 mark.
Killing the competition
So the theory is this: this is economic warfare on a grand scale. Opec has essentially recognised that it is losing its relevance because it was losing market share to US and other competitors in the oil production market.
This led it to flood the market with oil, driving down prices and forcing its competitors out of business, thus cementing its position as leader in the oil production game. (Opec output has averaged more than 32m barrels a day in 2016, compared with its former target of 30m barrels a day, according to ft.com.)
In the process it has managed to prevent new exploration projects from coming to market as banks are now extremely reluctant to fund oil exploration and production projects due to the massive losses many US shale producers are taking.
Note that there have been 15 liquidations to date that are significant. These include: Pacific Exploration & Production, which buckled under $5.3bn worth of debt; Samson Resources, which caved under $4.3bn and Ultra Petroleum, which collapsed under $3.9bn worth of debt. The list goes on. Those with small bank rolls could not survive the downturn.
The Saudis, however, don’t have small bank rolls. They have been earning some very healthy profits from oil for decades and even though they want to change the way in which their economy functions (by reducing their reliance on oil), they understand that there are a few more good decades of earnings to be had in this oil production game. The threat to that though was shale gas and green energy.
They may not have managed to stop the threat completely, but they have managed to delay it for at least one more commodity super cycle, and are currently in the process of cementing their position as the main source of the thick bubbly black stuff that the world is slowly realising it actually still needs.
Opec estimates that non-Opec supply peaked in 2015, and is expected to drop by 740 000 barrels a day this year as producers cut investment and production to conserve cash.
Considering that we are starting to see three major things happening, I would say that the Saudis’ plan is working. Firstly, the oil rig situation, as explained. The ability to compete against the Middle East in the production and supply of oil is greatly reduced.
Secondly, oil is currently trading in backwardation. What this means, in a nutshell, is that the spot price of oil (for immediate delivery) is more expensive than the forward price for oil (purchases for delivery at some point in future).
This means that all purchases that are taking place on the spot market for oil are being made for immediate consumption and not the building up of stockpiles as was the case just a few months ago.
Thirdly, there has been a fairly consistent monthly draw on crude oil inventories over the last couple of weeks. When considering that oil purchases are still being made (in the spot market under backwardation conditions) it necessarily follows that consumption is outpacing production, thanks largely to the vast number of oil rigs that are no longer operational.
The pieces are starting to fall into place, and this is being reflected in the steadily rising oil price.
Opec met on 2 June. Delegates didn’t agree to limits in terms of maximum production but, as expected, most came out of the meeting saying that no member country indicated a desire to continue increasing production. They also said a level of co-operation has been reached unlike they’ve had in many years.
This, to me, indicates that a stabilisation of oil production will be reached without major agreements needing to be made. Also, Opec members agreed that their next meeting will be held a month earlier than scheduled.
It is starting to look like the next agreement that will come out of an Opec meeting will not be one of capping oil production, but rather an agreement on a cut in oil production.
It’s starting to make sense. Flood the market, drown out the competition, reclaim dominance, then turn off the taps and reap decades’ worth of profit. The great oil shakedown, masterfully orchestrated.
This article originally appeared in the 16 June 2016 edition of finweek. Buy and download the magazine here.
