What's Going On With Oil Prices?

Oil does not want to behave.

When oil took a tumble in the back half of 2014, the question on most people's minds was, "When will it rebound?"

Like a battling UFC fighter in the fifth round, the oil price has struggled to pick itself off the mat. The fact is that there's just too much oil out there, and the surplus means that oil prices have continued to stay low.

What we really want to know is what the state of the market is, and whether it is going to stay this way for a while longer.

Source: FT.com

The oil glut

Low oil prices hurt producers. Lower for longer means companies like Chesapeake (CHK), Royal Dutch Shell (RDS.A, RDS.B) and Chevron (CVX) lose money on every barrel - a practice that simply can't be sustained long term. Research suggests the oil price required to fund energy enterprises is around $70/barrel. Exxon is the hardiest of the bunch, needing around $60 a barrel to break even. Even then, the current price of oil languishes at $50/barrel (as of June 2017).

The trouble is that more oil is being produced than people are demanding - 250,000 barrels a day, to be exact. That adds up. At that rate, in a year you'd end up with 46 supertankers, each one capable of holding 2 million barrels of oil, just sitting around with all the excess barrels of oil.

The solution? Just stop producing so much.

Easier said than done; reducing the amount of production calls for cooperation amongst the most important players and must take place on a global stage. Things get further complicated when one realizes that the players include Venezuela, a country that is in the top 10 of oil producers by barrels per day but is also wracked with economic instability. The extra income from selling additional barrels of oil isn't something that a country like Venezuela can easily turn down.

Furthermore, OPEC nations like Saudi Arabia, Kuwait and the UAE actively pursued policies of not cutting supply in an attempt to use lower prices to hurt countries like the US. The US has emerged over the last decade as a massive oil producer, and the hope was that by keeping prices low, higher-cost producers in the US and other places would bankrupt themselves trying to keep up.

It didn't work out so well. While some energy companies have gone bust, for the most part US oil has been resilient. At the same time, subsidizing cheap oil has eaten away at the reserves of countries like Saudi Arabia and Russia.

Promises made

The top oil producers in the world are Russia, Saudi Arabia and the US. Together, they represent about a third of the oil supply. Another important bloc when it comes to oil is OPEC, the Organization of Petroleum Exporting Countries, an organization that controls 80% of the world's oil reserves and produces nearly 40% of global oil supply.

OPEC wields a lot of power. And so, this cartel of oil producing countries came together and agreed to cut supply to try and push prices up. In November, the group agreed to cut supply for 6 months starting in 2017 - their first such consensus since the price crash. Where before Saudi Arabia had been fighting to protect its market share, the middle eastern nation finally agreed to cut 5% of its output. OPEC as a whole agreed to reduce production by 4.5%, or 1.2 million barrels a day. This was the first cut in 8 years.

Following that agreement, Russia and other non-OPEC nations also stepped up to say it would cut production, pledging to reduce another half-million barrels a day.

The results

21 countries tried to work together to limit oil production to around 1.7 million barrels a day. It sounds like a logistical nightmare with so many opportunities for one of the member nations to renege and sabotage the deal.

They did it, sort of.

All member nations except for Gabon, Malaysia, Kazakhstan and South Sudan actually followed through and cut production. Comically, Kazakhstan agreed to cut production by 20,000 barrels a day and then went and increased supply by 46,000 barrels a day. Yeesh.

Other than the four free-riders, the cut was more or less achieved. Even Russia, while not reaching its set target, reduced output by nearly a quarter of a million barrels a day.

Obviously, this concerted effort hasn't paid off yet. While prices increased following news of the November deal, prices since January (when the cuts actually started) have actually gone down as American producers stepped in to fill the gap left by OPEC members. In the last year, the number of active US oil rigs has doubled.

The OPEC nations met again and elected to continue with their efforts until March 2018, hoping that this would work off the excess oil. It just remains to be seen if they can bring the US into the fold. The US is sitting on 688 million barrels of emergency oil stockpiles, an accumulation that they would like to see reduced.

Conclusion

The whole saga is playing itself out. At first, there was too much oil and prices cratered. Saudi Arabia, the de facto head of OPEC, thought they could weather the storm and elected to continue with business as usual.

After nearly two years trying to bankrupt US oil producers, it looks like Saudi Arabia and OPEC have finally waved the white flag. Led by the Saudis, OPEC is charging ahead with their first supply cut in years, and we'll have to follow closely over the next 9 months to see what happens.

For prices to go up, all nations involved will have to step up their game and try to constrain countries such as the US that aren't part of the agreement.

The consensus is that the US won't be able to fully erase the cuts established by OPEC. It's also probably not in their best interests to do so. The EIA forecasts that the US can produce 1 million more barrels a day - that's more than half of the OPEC target.

Expect to see that tension play out on the global stage as oil creeps slightly higher this year. After that, who knows.