The United States Oil Fund (NYSEARCA:USO) has had a rough go of it in the past few years. Though a recent rebound saw crude prices bounce from lows shy of $30 per barrel to briefly into the low $40 range, prices have since then retreated back into the upper $30s while inventories have only continued to grow.
Most of the explanations for the recent bounce and the bulls' arguments for higher prices have centered on expectations of declining supplies in the near future. Per OPEC's predictions from March 2016, worldwide demand is not expected to change that much, growing only ~1.3% in 2016, about 80% of the rate it grew at in 2015.
While there are factors that could change the demand picture, clearly the more significant and volatile side of the equation currently on investors' minds is supply. Bulls are primarily looking to falling rig counts and an April 17th meeting of oil producing countries to support the theory that supplies will see significant cuts in the near term, thus boosting prices, however there are several major problems with this theory that investors in oil and related ETFs like USO should be aware of.
Problem #1: April 17th Meeting of Oil Producers Unlikely to Incur Any Significant Changes
Let alone that major oil producing countries like Saudi Arabia, Russia, Venezuela and Iran are not exactly known for their governments' forthrightness, ease of negotiations and transparency; let alone that Saudi Arabia and Kuwait just recently announced they would resume a jointly operated 300,000 bpd field following the first Doha meeting and in the face of the April 17th meeting; let alone that Iran has so far refused to partake in a production freeze while Saudi Arabia has said no agreement can occur without Iran- let alone all these things, when one steps back and simply logically analyzes the situation from the perspective of any given oil producing country, it becomes clear that no one is all that incentivized to participate in production cuts.
For those unfamiliar with game theory, Wikipedia has a good introduction here. Essentially, it involves examining a given player's strategy and options vs their opponent's options. When the outcomes of one player's strategy are more favorable than the alternative for any given strategy their opponent takes, that strategy is said to be 'dominant.' If we examine this context via game theory, one quickly sees that not participating in any production cuts is the dominant strategy for all individual members involved in negotiations.
For this thought experiment I laid out two scenarios:
- Scenario #1: Country A's Perspective
Country A is getting killed by the current low oil prices, and is desperate for cash flow right now (ex. Venezuela). They are less interested about long-term competition and more interested in revenues in the short-term
- Scenario #2: Country B's Perspective
Country B is hurting from low oil prices, but is in a relatively stronger financial position than their competitors, whether due to larger reserves or naturally lower production costs (ex. Saudi Arabia). For this country, while increased revenues in the short term are obviously desirable, there is also the possibility of taking more pain in the near term to drive their less stable and cost effective competitors 'out of business' and therefore capture even greater longer-term benefits
When we examine the situation from either of these perspectives, we see that for both Country A and Country B, their choice to Not Cut leads to a better outcome for them vs the alternative of choosing to Cut in both possible outcomes of OPEC choosing to Cut or OPEC choosing to Not Cut. Thus, for both types of countries a 'No Cut' strategy is dominant, meaning any given participant is better off not participating in cuts.
Thus when one really looks at the incentive structures and the individual participants' historical actions rather than their words- combined with the fact that even one country refusing to participate could derail the entire agreement- it quickly appears extremely unlikely that any significant changes will come out of the April 17th meeting.
Problem #2: Falling Rig Counts do Not Translate Proportionally to Less Production
While many investors have pointed to falling US rig counts as a sure sign of falling supply, unfortunately (for bulls) this has actually not played out, with oil production remaining relatively stable despite rig counts plunging to levels nearly 20% of what they were as recently as shortly over one year ago.
And while low rig counts could theoretically eventually translate to falling production as remaining rigs become less efficient and dry up, this theory ignores several important factors: 1) a commensurate proportional drop in production would take a long time to play out 2) the US is far from the only oil producer and in fact it is now cheaper for US refineries to import oil from other countries, meaning falling WTI production has less and less effect on total supply and prices (until at least WTI falls even further) and 3) this requires low rig count levels to stay consistently low, a requirement that is simply unrealistic (and one we will discuss right now in our next problem with the oil bull theory).
Problem #3: Vast Number of DUCs and Competitive, Cash Strapped Producers Puts a Ceiling on Prices
As a further challenge to the theory about low rig counts translating to lower supply, US producers currently have a record number of DUCs (drilled but uncompleted) wells which provide a relatively quick and cheap source of oil vs the alternative of new wells. With more than 4,000 DUCs currently, or more than 11x the current number of rigs, there are vast options for cash strapped producers to quickly resume selling oil should prices show any signs of rising.
In fact, similarly to how the April 17th talks are unlikely to produce effects because each party is incentivized to Not Cut, when combining the fact that US oil producers have record levels of DUCs, are currently desperate for cash flows, and are of course competing against each other for a relatively stable amount of demand, an effect that puts a ceiling on prices is created. To illustrate this principle more clearly, imagine a world where there are only two oil producers:
- Producer A is profitable at $35 per barrel
- Producer B is profitable at $40 per barrel
If prices rise to $39 per barrel, Producer A can either: a) wait for prices to rise more in the hopes of an even bigger future profit -or- b) ramp up production now and capture a relatively smaller profit.
To some producers who are less desperate for immediate cash flows and revenues, option 'a' might sound preferable, however the problem with option 'a' is that if they wait too long, eventually Producer B will step in and ramp their production back up, thus eroding Producer A's potential profits. Even worse, because they have been at a longer disadvantage, Producer B is likely even more desperate to immediately generate revenues and cash flow and may begin ramping up once prices barely budge above $40. If Producer A then joins at that point, an imbalance could quickly be created that sees prices fall once more, perhaps even lower than levels that are profitable for Producer A.
Thus, Producer A is directly incentivized to allow prices to rise a little, but not too much. Because of this effect and the vast number of desperate parties involved with vast reserves of relatively cheap oil, producers will effectively dampen any price rises by competing with each other over a relatively fixed size of demand for barrels of oil.
It's important to note that even bankruptcies won't necessarily fix this. Imagine a third producer, Producer C, goes bankrupt, and Producer A, being in relatively better financial shape, buys their assets at $.25 on the dollar. Suddenly, Producer A becomes even more cost effective at producing oil, with no change to the same total owned amount of oil reserves and rigs!
Problem #4: Low Interest Rates Create Self-Reinforcing Effect on Rising Storages
With oil markets currently in contango (prices further in the future higher than prices closer to the present), and record low interest rates, producers and speculators alike are financially rewarded for storing oil and selling it in the future.
The pace of construction for oil storage has increased to 547,000 barrels of new storage a week, and storages are near all-time highs. With low interest rates leading to lower financing costs to construct new storage, and those low construction costs in turn keeping leasing rates low, a self-reinforcing cycle has been created in which rising inventories leads to lower spot oil prices, which leads to more storage of inventories and so on...
As long as futures prices remain higher than current ones, the incentive will remain to pump oil and store it. That leaves the U.S. stuck in a strange pattern where "the higher inventories go, the more downward pressure that puts on near-term prices, which only increases the incentive to store it," says Citi Futures' Evans. The only way to break that cycle is for interest rates to rise, says Verleger, which would increase the financing costs to build storage tanks. "As long as money is cheap, it'll make sense to build storage tanks in the U.S.
With yet more signs from Yellen just this week that interest rates may remain low for a prolonged period of time, and growing evidence that low rates and deflation may be the new normal for the global economy, relief does not appear to be in the books in either the short or long term, and storages may simply continue to rise.
While oil prices and USO have fallen quite far from their above $100 per barrel days and rig counts and OPEC rhetoric have responded in kind, for several reasons these changes do not look to be enough to create sufficient cuts to supply to induce price gains.
Global demand is relatively stable, with more downside risks than upside (China), and growing supplies, storages and record levels of reserves and increasing cash-flow-desperate producers will likely lead to no material changes to supply.
Please share your thoughts in the comments and follow for more macro and commodity related analysis.
Disclosure: I am/we are short USO, UWTI.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.