It Won’t Be Long Before Oil Goes Back Up

The oil price collapsed last Monday after an acrimonious meeting of the Opec exporters’ cartel. Having been above $105 a barrel as recently as June 2014, US crude fell to $37.65. That represents a 64pc drop in just 18 months – to the lowest level since the worst of the global financial crisis in February 2009.

Oil plunged again last Thursday, moving below $37 – amid further evidence that Opec’s 12 member states, from the mighty Saudi Arabia to tiny Ecuador, are cracking up. After staying well above $40 a barrel for months, crude has now crashed decisively through that psychological lower bound. Now it’s been breached, there’s widespread speculation crude could tumble much further – maybe even as low as $20.

I don’t buy that. And just as fast as crudes prices have fallen over the last year or so, they could easily spring back. One reason is that these recent drops reflect supply patterns driven almost entirely by geo-politics – and geo-politics can quickly shift. It’s also axiomatically true that a collapse of the crude price from an average of $94 a barrel in 2014 to $49 so far in 2015 entirely contradicts the long-term fundamentals of ever-rising global oil demand and the geological and logistic constraints on future increases in supply.

Last November, Saudi Arabia decided that Opec wouldn’t cut its export quota in the face of falling prices. The idea was to keep pumping like billy-o to drive prices even lower, knocking upstart and relatively high-cost US shale producers out of the market.

Opec’s strategy has worked in the sense that we now have a short-term supply glut which, together with a slowing Chinese economy and expectations Iranian oil could soon hit global markets, has resulted in big price falls. It’s also caused a slowdown in the rate of growth of American crude production – which rose 16pc to 8.7m barrels a day in 2014, but is this year on course to grow just 7pc to 9.3m barrels daily, as many shale producers have indeed suffered from low prices and been forced to close.

Far from retreating, though, Riyadh is pursuing race-to-the-bottom pricing even further. No matter that Opec-member Venezuela, reliant on oil for over 90pc of its export revenues and enduring a 9pc GDP contraction this year, is on the brink of civil war.

No matter that war-torn Libya, battling Islamic State and in the midst of its own civil conflict, is producing just 400,000 barrels a day, down from 1.5m under Gaddafi, absorbing the twin revenue shock of both far lower output and a much reduced price.

No matter that even Saudi itself is suffering – with cheap oil resulting in a 20pc of GDP budget deficit, and a large share of its fast-growing 30m-strong population highly reliant on oil-funded government handouts. In February, the newly crowned King Salman dished out a reported $32bn to the Saudi people to “celebrate” his ascension to the throne – providing a stark illustration of the money-for-power bargain that sustains the House of Saud. If the money dries up, and Saudi Royalty can’t pay, the world’s pivotal oil power could be plunged into political and civic chaos.

With the stakes so high, oil having fallen so far and US shale production dented, many expected Saudi to relent at last weekend’s Opec summit by announcing a new lower production cap. But it didn’t happen. Delegates left the meeting “visibly angry”, with some displaying “blank stares”.

One problem for Riyadh is that the US shale industry has shown grit and determination, with many small- and medium-sized shale producers clinging on – and the Saudis don’t want to lose face. At the same time, if a new production cap is announced, the Saudis don’t trust other large Opec members like Iraq (and particularly arch-rival Iran, once sanctions are lifted) not to break it, so muscling in on Saudi’s market share.

Then there’s Russia, outside Opec and constantly vying with the Desert Kingdom to be the world’s biggest oil producer. An Opec production cut, the increasingly paranoid Saudis fear, would make yet more room for Russian crude. And Moscow is less bothered about cheap oil than Riyadh – given that, in ruble terms, prices haven’t fallen nearly as far.

The Saudis have revealed, then, their fear that Opec is now so stretched, its member states so rattled, that a new production cap wouldn’t stick, paving the way for “every man for himself” quota-cheating on a big scale, with non-Opec rivals also moving to grab market share. Were that to happen, the power of the cartel, which still controls a third of all global oil production, would ebb away entirely.

Since meeting last weekend, Opec has revealed that total production rose 230,100 barrels a day in November from the month before, to 31.695m barrels – a four-year high, driven largely by increased production in Iraq. Having just failed to announced a new production cap, then, Opec just formally broke the existing 30m barrel ceiling – and by a wide margin. That’s why these new numbers caused oil to drop even more – because they signalled that Opec, as a supply restricting mechanism, is now in pieces.

Having said all that, I still reckon crude could bounce back soon. One reason is that the “Chinese demand is falling” argument has been overdone. Yes, China is now growing by 5-6pc a year, rather than the 9-10pc annual average it has chalked up since the early 1990s. But the Chinese economy is now far bigger than it was just a few years ago – so its oil use still rises substantially, from year to year, even if growth slows. The People’s Republic is on course to consume 11.2m barrels a day this year, according to the Energy Information Agency, a branch of the US government. That 2.8pc up on 2014. Another 2.7pc increase in Chinese consumption is penciled-in for 2016.

In the US, meanwhile, while oil inventories remain high, there are signs they’re now peaking. The EIA just announced that US crude-stocks fell 3.6pc during the first week of December, snapping a streak of 10 consecutive weeks of increases.

At the same time, the plucky US shale industry, having put on a brave face, is showing signs of genuine strain. Over the last year, the US “rig count” – the number of separate oil production centres in operation – has dropped by a staggering 62pc. So far in December, we’ve seen a 7pc fall in a single week. It’s not surprising, then, that the EIA, is now officially forecasting a hefty 6.1pc cut in US oil production next year, to 8.7m barrels.

Then there’s the broader truth that the “solution to low oil prices is low oil prices” – with cheap crude causing low investment in production and exploration, so sowing the seeds of a future price rise. During 2015, the international rig count (outside the US) has so far fallen a massive 16pc. Across the world, investment in oil exploration and production has nosedived from $700bn in 2014 to $550bn this year. With oil now below $40 a barrel, remaining investment projects will be dropping like flies.

Western equity markets continue to soar. Distress levels in junk bond markets, meanwhile, are now at their highest since September 2009, according to Standards & Poors. That alarming statistic is derived largely from highly-leveraged North American energy producers doing everything they can to survive in this environment of artificially cheap crude.

So, low oil prices feel nice. But there will be relief in many quarters, not just among Opec members, when prices go back up.

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