Oil Price Rebound Guaranteed!
The Secretary General of OPEC offered some interesting insights when he was questioned by CNN recently. Abdulla al-Badri believes that it is the non-OPEC oil producing countries – the USA and Russia specifically – who were caught by surprise when OPEC refused to cut oil supply to stem rapidly falling oil prices. Al-Badri made clear that the Organisation of Petroleum Exporting Countries acted purely out of economic interests in opting to maintain production at current levels. Further, he believes that the oil market has bottomed out and that there is nowhere else to go but up. The Russians are continuing to maintain their supply of oil production, but shale producers are beginning to reduce their supply as prohibitive costs begin to impact on the industry.
OPEC Secretary General is All Smiles on the Surface but Oil Wells Run Deep
It is interesting to note precisely how high OPEC Secretary General al-Badri sees oil prices going. A figure of $200 per barrel was bandied about among OPEC insiders, but others believe that oil could go as high as $100 a barrel within the next 12 to 18 months. Presently, the price of Brent crude oil is $54.16 per barrel and the price of the WTI crude oil is $48.45 per barrel. OPEC, led by Saudi Arabia has a keen interest in seeing US shale oil producers reducing their output. Economics 101 states that when there is an oversupply of a commodity, buyers will continue to shop for lower prices. For the suppliers, the more they keep producing at depressed prices, the greater their inventories become. When that inventory reaches ‘Critical Mass’, production shuts down and supply is reduced – thereby restoring equilibrium to the markets.
US shale oil producers have been particularly hard-hit by the low price of oil. Fracking is an expensive undertaking, and the industry is plagued by high labor costs, high drilling costs and high extraction costs. The number of applications for new oil well permits in the US tapered off significantly in November 2014, and the preponderance of low prices makes it unprofitable to continue production at current levels. Complicating the issue further is the issue of longevity of the drilled product. Saudi oil wells have a much longer life-cycle than fracking wells. Shale oil fracking incurs much higher costs per employee as shale wells are far away from previously drilled sites. This means that the costs of establishing a short-term base of operations are higher to entice drillers and their families to setup home near the wells. The conditions under which US drillers operate are vastly different to those in the Middle East. Winter temperatures in fracking states can drop well below zero, thereby driving up the labor costs of maintaining a profitable base of operations.
How OPEC Sees the Current Oil Situation
According to the Secretary General of OPEC, the market will correct itself. OPEC countries are not likely to go back on their decision about maintaining current supply. It is clear that OPEC is in a strong position, given the deep pockets of major oil-producing countries like the United Arab Emirates, Kuwait, Saudi Arabia et al. While smaller oil producing nations in OPEC are hurting, the big producers can sustain the effects of oil price weakness. Mention has already been made of the spending cuts implemented by major oil producers, as companies reduce their spending following unsustainable oil prices.
One of the biggest names in the business – British Petroleum (BP) – announced that capital expenditures will be cut by approximately 20% in 2015 and the company will put various investments on hold as weak oil prices impact heavily on the markets. This year alone, BP is expected to cut exploration/production spending to $20 billion – down $6 billion from previous forecasts. Royal Dutch Shell will reduce its capital investments by $15 billion between 2015 and 2017 and Chevron will cut its expenditures by as much as 13%. Other oil producers have followed suit with Gazprom (GZPFY) cutting spending by $8 billion, and China-based CNOOC (CEO) expected to reduce its expenditures by 35% in 2015.
Divestiture and Cutbacks Have Severe Repercussions for the Oil Market
This all goes back to the core issue of cause/effect in oil markets. Now that companies are trimming their capital expenditures vis-a-vis oil exploration, there are likely to be future shortfalls which will push prices up much higher than they currently are. The oil industry requires continuous exploration and investment in order for price stability to be maintained. What companies are doing now will ultimately bring higher prices to consumers around the world. Saudi Arabia, Kuwait, the UAE and other leading OPEC countries may be opting to lose this battle, in order to win the war. But that too does not tell the full picture in the commodities market, since alternative energy sources are being developed to quell global demand for WTI crude oil and Brent crude oil.
As the world's economies begin to mend and production begins to increase, so the global appetite for oil and its refined products will increase too. China may have over-ordered raw materials in 2014, but its economy will likely bounce back and oil demand will increase once again. Analysts warn that it is imperative not to cut back on oil exploration, since each oil well declines by an average of 5 percent per annum. Since mature oilfields decline at such a rapid rate, trillions of dollars in additional investments are required to meet global demand. It must be remembered however that a delay in infrastructure investment in 2015 will not have an immediate impact on oil supply in the future. The lead-time of major oil field exploration and development has a lag of several years.
The Verdict
There has long been suspicion that OPEC's decision to maintain its current supply of oil is intended to squeeze the burgeoning US shale oil market out of business. While the Secretary General may have alluded to purely ‘economic’ reasons for maintaining the current supply, squeezing the US and other oil producers out of the market certainly qualify as economic reasons. It is hard to say whether the market has bottomed out, because there are several key elements weighing heavily on this assumption. For starters the eurozone is teetering; Greece recently voted for the ultra-leftist Syriza party and that will impact on European currency. Japan continues to experience recessionary fears and Russia has been downgraded to junk status by major credit rating agencies. Standard and Poor's announced that the Russia’s downgrade in the credit markets is attributed to the punitive sanctions imposed by the West vis-a-vis the Ukraine crisis, the collapse of the ruble and punishing oil prices. Add to that the geopolitical uncertainty generated by the rising power of ISIS in the Middle East, and the possibility of a broader war that now includes Jordan and other Arab countries. It is uncertain at best which way the oil price will move given the state of the global economy.