This interview was conducted May 14th 2015
What is the state of the Oil markets? More specifically, how are politics and the global macro events trumping supply and demand in the trading of the Oil futures markets?
In late 2014, Saudi Arabia kicked off a crude oil price war in quiet recognition that US shale represents an existential threat. Now the pressure on shale companies is starting to show results.
When Saudi Arabia realized that US shale had the potential to become the new “swing producer” for global oil supply, there was really no alternative to price war. The old playbook was torn up forever with the presence of this new force in markets. In the old pre-shale days, Saudi Arabia could keep the oil price high – or at least stabilize it – by cutting back supply when demand softened. This worked because Saudi production closed the gap in the global supply and demand balance for crude. By making adjustments, the house of Saud could turn marginal pressure on crude oil prices into marginal support, by way of restricting supply until demand levels slightly exceeded supply levels once again.
With the new producers on the scene, however, any cutback in Saudi supply would simply be met by a US shale supplier. Let’s say there is global equilibrium between oil supply and oil demand at 90 million barrels per day. If demand levels slipped to, say, 89.5 million barrels per day, that would produce downward pressure on the price of oil… until the Saudis cut 600,000 barrels per day worth of production, bringing supply a notch below the new demand level. But now you have US shale fracking on the scene providing an extra couple million barrels per day. With the addition of U.S. shale, Saudi cuts would NOT bring supply and demand back to balance. Supply levels would remain above soft demand levels regardless. Now, any supply cut by the Saudis, would only be giving money to the U.S. shale producer, filling in as the new global oil “Swing Producer”.
Another way to understand OPEC, both pre- and post-shale, is to think in terms of price collusion. When a few companies (or countries) dominate a market, they can get together and decide to keep prices above a certain level. If just one player decides to break the pact, however, they can sell with size at lower prices than everyone else, and prices are forced down across the board. The U.S. shale fracking industry was the odd man out and basically, threw in a huge monkey wrench for the colluders.
What are the key opportunities and challenges facing the Oil & Gas industry?
There are several opportunities and challenges facing the Oil & Gas industry. When the US shale boom arrived in and ramped up US crude oil production by nearly 4 million barrels in five years, the Saudis knew their control regime was in serious trouble. From a long-term perspective it was clear that, if U.S. shale just kept pumping, the oil price could fall drastically. Furthermore, oil prices could then stay low permanently. Imagine a world in which global oil supply consistently exceeded demand, by a few million barrels per day, for years on end. That would be a nightmare for OPEC. The Saudi solution is to kill off high cost producers sooner rather than late, and make sure they are good and dead. This will ensure U.S. production so that current production is scrapped and new production is mothballed. Theoretically, enough short-term pain could give the Saudis their swing position back. If short-term pain is great enough to bankrupt a whole slow of producers and shutter a hundred-billion-plus worth of longer term projects then at some point down the road, the global supply / demand balance will favor supply again, and the Saudi financial future will be better assured. The plan only makes sense, however, if the Saudis finish what they started. Saudi Arabia will not let the oil price rise too much now, after investing so heavily in a strategy to crush the shale enemy. However, given this threat, opportunities have arisen to produce a barrel of oil more efficiently and to enter different markets through acquisitions. This efficiency, is a result of better bargaining power from producers, technological advances that produce efficiencies, strategic acquisitions of producers by larger better capitalized companies, for example, Shell’s acquisition of BG Group. As always in the oil and gas industry challenges yield innovation and opportunity.
According to Daniel Yergin, vice chairman of IHS, the Oil market is “going to be a lot more volatile.” Do you agree with this statement, and if so, why?
Yes, I absolutely agree with Mr. Yergin. The retreat in U.S. oil drilling is a prime example of how the market will play out in the future. Oil prices began collapsing in September, and yet U.S. producers didn’t really start pulling rigs out of fields until December. When prices rebound, their return to shale fields will again take months.
OPEC, but more so, the Saudis, could snap their fingers and make prices rebound by tomorrow. Hence in essence there is a whole sector of a couple hundred companies, countries, and political regimes, looking out for their own self-interests. Throw in the cross current effects of global currency moves and their impact on oil priced in dollars and the uncertainty only grows. With so many forces at play, the end result is a volatile market that is at the mercy of such forces.
The International Energy Agency noted that competing forces are still playing out in the market, making the direction of prices difficult to discern. With this said, how sure can we be on our predictions?
The International Energy Agency is correct that competing forces are still playing out in the market, making the direction of prices difficult to discern. As for predictions in prices, we can’t be sure, since any change in regulations, geopolitics, M&A activity, global growth or lack thereof, global interest rates and moves undertaken by global central banks would have a material effect on oil price predictions. Unless, you can predict every single political event outcome, adjust for the different political regime agendas, and account for how global central banks will leverage interest rates and their respective currencies to stimulate their economies, you can’t predict global energy prices with great certainty and be 100% confident in your price predictions.
As international sanctions have sharply reduced Iran’s sales of Oil, what would be the potential effect on Oil supplies if the proposed nuclear accord with Iran eases and/or lifts those sanctions?
A huge uncertainty in the oil market is the potential effect on oil supplies of a proposed nuclear accord with Iran, a major producer. International sanctions have sharply reduced the country’s sales of oil, and an accord is expected to ease, or lift, those sanctions. However, the U.S. Senate has just passed a bill that would require congressional approval and review on any deal with Iran. In addition, since Congress imposed many of the sanctions on Iran, any lift of Iranian sanctions imposed by Congress, could not be bypassed by president Obama through the U.N. The bill passed the Senate with bipartisan support and should easily pass the House of Representatives, with its GOP majority. Therefore, this deal is very much up in the air.
However, if an accord was to be reached and sanctions were lifted so that Iran could legitimately sell its oil in the global market, it would take time for Iran to organize the enormous investment that would be required to sustainably bolster its production capacity; the country might be able to make short-term changes to increase output and exports relatively quickly.
Iran has 30 million barrels of oil stored on tankers, which could quickly feed an increase in exports. It has also been estimated that Iranian oil fields could ramp up production to as much as 3.6 million barrels a day, a 29 per cent increase, within months of sanctions being lifted.
Under the pressure of sanctions, both Iranian production and exports have been curbed. Many reporting agencies state that Iranian exports are down about 50 per cent since 2012, to an average of around 1.1. Million barrels a day, although some reports state they rose to 1.3 million barrels a day in March on high demand from China.
The issue I see here is the one of geopolitics. First, with the U.S. shale already threatening Saudi price dominance, surely Saudi would not be pleased with Iran pumping crude back onto the global oil markets thereby, further threatening Saudi pricing power. Secondly, there is the proxy war being fought by Iran backed Houthi rebels, and the coalition of Saudi, Egypt, Israel and other countries. None of the coalition countries want Iran to have access to more funding to support its proxy war. This is secretarian conflict for some of the countries involved, but for Israel, its very existence it feels is in question. So the question is if sanctions were lifted and Iran benefited from the renewed source of revenue, how would the coalition countries respond? Would it trigger a nuclear arms in the Mideast, as most of the countries in the Mideast believe whatever nuclear deal is reached that Iran would cheat, just it as has had on previous agreements. Would it be the final indicator that prompts Israel to take matters into its own hand and bomb Iranian Nuclear sites? The short term impact on the oil market should there be a nuclear deal, might be more oil supply from Iran thereby further depressing crude prices but this could change on a dime depending on the reactions of the coalition countries. I think supply/demand are indicators that are certainly the crux in the formation of a commodities price but with Oil, geopolitics are the dominant theme to be followed closely in the formation of short, medium, and long term outlooks.