A Fake Freeze on Oil Out­put is Good Enough

The Economic Times - - Money - LEONID BER­SHID­SKY

In less than a week, ma­jor oil-pro­duc­ing na­tions will meet in Qatar to dis­cuss cap­ping their out­put. Yet even if they de­cide to do that, the pur­pose of the meet­ing prob­a­bly has lit­tle to do with bal­anc­ing global sup­plies. Crude mar­ket fun­da­men­tals are set for many months to come; the oil pro­duc­ers are more in­ter­ested in find­ing a way to man­age fi­nan­cial mar­kets’ ex­pec­ta­tions, which have a greater ef­fect on prices.

A freeze “at re­cent pro­duc­tion lev­els would not ac­cel­er­ate the re­bal­anc­ing of the oil mar­ket,” Gold­man Sachs an­a­lysts wrote in a re­port that ar­gued the meet­ing would be more likely to lead to a price drop than a hike. And in­deed, out­put lev­els are close to all-time records for the Or­ga­ni­za­tion of Petroleum Ex­port­ing Coun­tries (above 33 mil­lion bar­rels a day) and near the his­toric high for Rus­sia, a par­tic­i­pant in the Doha meet­ing (above 11.2 mil­lion bar­rels a day). Be­sides, some OPEC mem­bers are in­creas­ing out­put ahead of the meet­ing. Iraq, for ex­am­ple, hit its pro­duc­tion record — 4.55 mil­lion bar­rels a day — in March.

US pro­duc­ers are head­ing in the op­po­site di­rec­tion. Their out­put is down to late 2014 lev­els. Fol­low­ing the pro­duc­tion de­cline, bloated US oil in­ven­to­ries ap­pear to be start­ing to slide, too. Though they’re still near all-time records, on April 6 the US gov­ern­ment re­ported an al­most 5 mil­lion bar­rel drop.

The sur­pris­ing re­silience of US oil pro­duc­tion is by now a mar­ket meme. Yet there is noth­ing mirac­u­lous about the oil in­dus­try. Pro­duc­ers can rely on crutches like price hedges or tech­no­log­i­cal ad­vances, but at the end of the day, it’s all about how much smelly dark liq­uid they can ex­tract from the ground at the right cost. US frack­ers may have been bet­ter than any­one else at us­ing these crutches, but now their im­pact is ex­hausted or re­ced­ing. In the rel­a­tively free US mar­ket, profit po­ten­tial drives in­vest­ment and out­put. And on both these fronts US pro­duc­ers are feel­ing the strain.

Per­sian Gulf states and Rus­sia need to pump oil at any price be­cause that’s how they fund their bud­gets, so when the price is low, they need to pump more. This is how it’s go­ing to be at least for the next few years: The tra­di­tional pro­duc­ers are go­ing to win back some lost mar­ket share. The big­gest prob­lem they face has noth­ing to do with the phys­i­cal de­mand-sup­ply bal­ance of oil. They need to keep prices as high as pos­si­ble, but low enough to pre­vent US in­vest­ment and out­put from ris­ing again.

The only way to do that is to man­age ex­pec­ta­tions. Domenico Favoino and Ge­org Zachmann of Bruegel re­cently es­ti­mated that 73% of the oil price de­crease in the last three years could be at­trib­uted to ex­pec­ta­tions about the phys­i­cal de­mand-sup­ply bal­ance, not the bal­ance it­self. Ac­cord­ing to the re­searchers, the role ex­pec­ta­tions play in price set­ting has in­creased dra­mat­i­cally since 2008.

This is a world in which you have to con­vince traders that the bal­ance is go­ing to move this way or that, not to ac­tu­ally change it. That ex­plains, at least in part, the mini-rally since the largely mean­ing­less Fe­bru­ary agree­ment be­tween Rus­sia and Saudi Ara­bia, as well as Qatar and Venezuela, to freeze pro­duc­tion at Jan­uary lev­els. The price of Brent crude is up about $10 per bar­rel.

Every­one un­der­stands that such deals are iffy, that the par­ties won’t nec­es­sar­ily stick to them, and that freez­ing pro­duc­tion at record lev­els may just sig­nify an in­abil­ity to pump much more oil in the near fu­ture. Yet it’s still some­thing to trade on. If the talks in Doha on April 17 end in an agree­ment, even a sym­bolic one, that will send the mar­ket a sig­nal to drive up the price.

That sig­nal, how­ever, will not be cred­i­ble or last­ing enough to spur an in­crease in US oil in­vest­ment. In­vestors and cred­i­tors are more cau­tious than traders. The for­mer are scared off by high volatil­ity; the lat­ter are en­er­gised by it. In Fe­bru­ary, the im­plied volatil­ity of the Brent crude price was the high­est since 2009, at 70%; now it’s down to about 50% — still a scary level for peo­ple look­ing at energy in­dus­try busi­ness plans.

The Saudis and the Rus­sians, how­ever, don’t care about the volatil­ity all that much: They’re still go­ing to keep pro­duc­tion as high as they can. So if they can send prices higher with­out sig­nal­ing a real change of trend, that’s the best they can do un­til they so­lid­ify their mar­ket share gains. Hold­ing a meet­ing where pro­duc­tion caps and cuts are dis­cussed is one way of achiev­ing that. News of the meet­ing can com­bine with shrink­ing US out­put to pro­duce tem­po­rary price rises.

It’s im­por­tant to pro­duce such news reg­u­larly. It’s less im­por­tant to be bound by out­put-lim­it­ing agree­ments, as OPEC has proven time and again by not stick­ing to out­put tar­gets. — Bloomberg

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