It still pays to pump crude oil

Financial Mirror (Cyprus) - - FRONT PAGE - By Tom Hol­land

The dog days of Au­gust have proved any­thing but dull for the oil mar­ket. As chat­ter be­gan to cir­cu­late about a pro­duc­tion freeze next month, funds rushed to cover their shorts and put on new longs in the fu­tures mar­ket. In re­sponse the bench­mark Brent crude price re­bounded some 17% in the first two weeks of the month to within a whisker of US$50/bbl, re­vers­ing much of its -21% cor­rec­tion since early June. It feels very much as if we have seen this movie be­fore, and not that long ago. In April, prices ral­lied smartly on talk that Saudi Ara­bia, Rus­sia and Iran would agree a freeze, only for the chat­ter to come to noth­ing. So the ques­tion in­vestors must an­swer now is this: What, if any­thing, has changed since then?

On the de­mand side, not much. If any­thing, the out­look has de­te­ri­o­rated. This month the In­ter­na­tional En­ergy Agency cut its de­mand growth fore­cast for 2017 to 1.2mn bbl/day, from 1.4mn this year, blam­ing a gloomy eco­nomic out­look. Mean­while, China’s im­port growth, long a bright spot in an oth­er­wise clouded mar­ket, ap­pears to be abat­ing as the slow­down in heavy in­dus­try weighs on de­mand for heav­ier oil prod­ucts, and as Bei­jing’s strate­gic re­serve buildup ap­proaches the lim­its of its cur­rent stor­age ca­pac­ity.

As a re­sult, at­ten­tion has fo­cused on the sup­ply side of the equa­tion. At first, there ap­pears lit­tle cause for bullish­ness. In­creases in OPEC pro­duc­tion have more than off­set the de­cline from non-OPEC pro­duc­ers re­cently, as Nige­ria brought ca­pac­ity back on stream and Saudi raised its monthly out­put to a record 10.67mn bbl/day in July.

Nev­er­the­less, the mar­ket has seized on com­ments from the oil min­is­ters of Saudi and Rus­sia in re­cent days, both of whom said that OPEC and non-OPEC pro­duc­ers alike are work­ing to­gether to sta­bi­lize prices. The re­marks raised ex­pec­ta­tions of an agree­ment to limit pro­duc­tion when of­fi­cials meet next month in Al­ge­ria, push­ing fu­tures prices higher. Whether any deal will ma­te­ri­alise is doubt­ful, how­ever. Saudi and Rus­sia agreed back in Fe­bru­ary to work to­wards a freeze, but noth­ing came of it. Saudi of­fi­cials have re­peat­edly de­clared that they will only limit their own out­put if other pro­duc­ers play along— by which they mean Saudi’s re­gional ri­val Iran. Hopes for a res­ur­rected deal rest on the be­lief that Rus­sia’s word car­ries weight in Tehran. That’s ques­tion­able. Rus­sian and Ira­nian in­ter­ests are aligned in Syria, where strate­gic co­op­er­a­tion is in­ten­si­fy­ing, and both coun­tries share a re­flex­ive dis­trust of the US, but Rus­sian in­flu­ence only goes so far. Ira­nian of­fi­cials are con­vinced that Saudi has stepped up pro­duc­tion specif­i­cally in order to sab­o­tage Iran’s oil ex­port prospects fol­low­ing the re­lax­ation of in­ter­na­tional sanc­tions at the be­gin­ning of this year, and in­sist they will not curb their own pro­duc­tion. Just last week Iran’s oil min­is­ter pledged to in­crease pro­duc­tion from 3.6mn bbl/day cur­rently to 4mn by the end of this year and to 4.6mn by the end of the decade. Iran’s state oil com­pany talks of pump­ing 6mn.

In such an en­vi­ron­ment, Saudi has lit­tle in­cen­tive in ei­ther the short or long term to limit its own pro­duc­tion. Riyadh’s im­me­di­ate ob­jec­tive is to gen­er­ate as much oil rev­enue as it can in order to pre­vent any de­te­ri­o­ra­tion of its fis­cal deficit, which the In­ter­na­tional Mon­e­tary Fund fore­casts at 13% of GDP this year. As a re­sult, a deal to freeze pro­duc­tion would only make sense if Saudi could be ab­so­lutely con­fi­dent that all the other sig­na­to­ries would com­ply. If Saudi were to limit its out­put while oth­ers did not, Riyadh would lose mar­ket share with­out any com­pen­sat­ing in­crease in price, and its rev­enues would de­cline. In the ab­sence of any such con­fi­dence, the least risky course is for Saudi to keep pump­ing as fast as it can.

Max­imis­ing pro­duc­tion may well make sense in the longer term as well. At cur­rent rates of pro­duc­tion, Saudi has an­other 60 to 70 years of proven oil re­serves (not fac­tor­ing in im­prove­ments in ex­trac­tion tech­nol­ogy, which in­crease re­serves even with­out new exploration). With mount­ing con­cern about cli­mate change likely to squeeze the mar­ket for fos­sil fu­els over the com­ing decades, Riyadh faces the risk that to­wards the mid­dle of this cen­tury it will find it­self sit­ting on 100bn bbl or more of “stranded as­sets” — proven oil re­serves that it can no longer ex­tract and sell. As a re­sult, Saudi has a pow­er­ful in­cen­tive to mon­e­tize as much of its re­serves as pos­si­ble as soon as pos­si­ble, by pump­ing as much oil as it can while it has the op­por­tu­nity in order to fund at­tempts to build a less oil-de­pen­dent econ­omy.

All these fac­tors — to­gether with the con­sid­er­a­tion that the av­er­age well­head breakeven price for new US shale wells is around US$40/bbl, mean­ing that new projects can be prof­itable at oil prices not far north of US$50-60/bbl — will con­tinue to place a firm ceil­ing on the price of crude some­where in the vicin­ity of US$55/bbl. De­spite the cur­rent flurry of bullish­ness, noth­ing ma­te­rial has changed.

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