The lim­its of oil’s re­bound

Financial Mirror (Cyprus) - - FRONT PAGE -

As it hap­pened, the price of Brent crude did fluc­tu­ate be­tween $50 and $70 in the first half of last year, be­fore plung­ing de­ci­sively be­low $50 in early Au­gust, when it be­came ob­vi­ous that the lift­ing of sanc­tions against Iran would un­leash a mas­sive in­crease in global sup­ply. Since then, $50 has in­deed proved to be a ceil­ing for the oil price. But now that this level has been ex­ceeded, will it again be­come a floor?

That seems to be what many in­vestors are ex­pect­ing. Hedge funds and other “non-com­mer­cial” spec­u­la­tors have in­creased their long po­si­tions to an all-time high of 555,000 of the main oil con­tracts traded on the New York fu­tures mar­ket, com­pared to the pre­vi­ous record of 548,000 con­tracts, set just be­fore the oil price peaked at $120 in June 2014.

The re­turn of spec­u­la­tive en­thu­si­asm is usu­ally a reli­able sign that the next big price move will prob­a­bly be down. More im­por­tant, the fun­da­men­tal ar­gu­ments are more compelling than ever that $50 or there­abouts will con­tinue to be a price ceil­ing, rather than a floor.

The case be­gins, as it did in Jan­uary 2015, by ob­serv­ing that the oil mar­ket is no longer con­trolled by the mo­nop­oly power of OPEC (or the Saudi govern­ment and OPEC). Be­cause of new sources of sup­ply, ad­vances in en­ergy tech­nol­ogy, and en­vi­ron­men­tal con­straints, oil is now op­er­at­ing un­der a regime of com­pet­i­tive pric­ing, like other com­modi­ties do.

This is what hap­pened for two decades from 1985 to 2004, and, as the chart be­low shows, trad­ing in the spot mar­ket dur­ing the past 18 months has been con­sis­tent with this idea. So has trad­ing in the fu­tures mar­ket: oil for de­liv­ery in 2020 has fallen to $56, from $75 a year ago.

If this com­pet­i­tive regime con­tin­ues, the price of oil will no longer be de­ter­mined by the needs and de­sires of oil­pro­duc­ing gov­ern­ments. Saudi Ara­bia or Rus­sia may want, or even “need,” an oil price of $70 or $80 to bal­ance their bud­gets.

But oil pro­duc­ers’ need for a cer­tain price does not mean that they can achieve it, any more than iron-ore or cop­per pro­duc­ers can achieve what­ever price they “need” to keep pay­ing the div­i­dends their share­hold­ers ex­pect or want.

Sim­i­larly, the fact that many debt-bur­dened shale pro­duc­ers will go bank­rupt if the oil price stays be­low $50 is no rea­son to ex­pect a re­bound. These com­pa­nies will sim­ply lose their oil prop­er­ties to banks or com­peti­tors with stronger fi­nances.

The new own­ers will then start to pump oil again from the same acreage, pro­vided prices are above the mar­ginal cost of pro­duc­tion, which will now ex­clude any in­ter­est pay­ments on loans that are writ­ten off.

A clear il­lus­tra­tion of the “regime change” that has taken place in the oil mar­ket is the cur­rent re­bound in prices to around the $50 level (the likely ceil­ing of the new trad­ing range). The steep­est part of this in­crease oc­curred af­ter April 17, when OPEC failed to agree on a new price tar­get and per­suade the Saudi, Rus­sian, and Ira­nian gov­ern­ments to co­or­di­nate the out­put cuts that would be re­quired to achieve any such tar­get.

Now that all of the main oil pro­duc­ers are un­equiv­o­cally com­mit­ted to max­i­miz­ing pro­duc­tion, re­gard­less of the im­pact prices, oil will con­tinue to trade just like any other com­mod­ity (for ex­am­ple, iron ore) that is in over­sup­ply in a com­pet­i­tive mar­ket. Prices will be de­ter­mined as de­scribed in any stan­dard eco­nom­ics text­book: by the mar­ginal costs of the last sup­plier whose pro­duc­tion is needed to meet global de­mand.

When oil de­mand is fairly strong, as it is now and tends to be in early sum­mer, the price will be set by the mar­ginal pro­duc­tion costs in US shale basins and Cana­dian tar sands. When de­mand is weak, as it of­ten is in au­tumn and win­ter, the mar­ket-clear­ing price will be set by mar­ginal pro­duc­ers of cheap but less ac­ces­si­ble oil in Asia and Africa, such as Kaza­khstan, east­ern Siberia, and Nige­ria.

From now on, the costs faced by these mar­ginal pro­duc­ers will set the top and bot­tom of oil’s trad­ing range. Low-cost pro­duc­ers in Saudi Ara­bia, Iraq, Iran, and Rus­sia will con­tinue to pump as much as their phys­i­cal in­fras­truc­ture can trans­port as long as the price is higher than $25 or so. The price needed to elicit enough pro­duc­tion from US shale and Cana­dian tar sands to meet strong de­mand may be $50, $55, or even $60, but it is un­likely to be much higher than that.

Un­pre­dictable shifts in sup­ply and de­mand will, of course, cause fluc­tu­a­tions within this trad­ing range, which past ex­pe­ri­ence sug­gests could be quite large.

In the 20-year pe­riod of com­pet­i­tive pric­ing from 1985 to 2004, the oil price fre­quently dou­bled or halved in the course of a few months.

So the near-dou­bling of oil prices since mid-Jan­uary’s $28 low is not sur­pris­ing. But now that the $50 ceil­ing is be­ing tested, we can ex­pect the next ma­jor move in the trad­ing range to be down­ward.

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