It still pays to pump crude oil
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.