Revised OPEC Production Quotas Won't Derail Higher Oil Prices

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Includes: BNO, DBO, DNO, DTO, OIL, OILK, OILX, OLEM, OLO, SCO, SZO, UCO, USL, USO
by: Albert Goldson

Summary

Oil prices to continue upward trend based on supply constraints and disruptions against robust global demand despite OPEC plans to loosen production quotas.

IEA officials warn that oil market’s shrinking spare capacity is vulnerable to shocks and destabilizing price spikes.

US shale oil is unable to fill global supply shortfall until late 2019 at earliest because of infrastructure constraints.

Wild cards Libya and Nigeria oil production is hobbled byinternal strife.

Venezuelan oil production is in free-fall and could possiblygo “off-line” by the end of 2018.

The Saudis and Russians recently met in informal discussions for the purposes of formulating plans on the loosening oil production quotas ahead of the OPEC meeting June based on a recently achieved balance between supply and demand but against looming potential multiple disruptive production and supply threats.

Nonetheless the Saudis and Russians have competing objectives in achieving a revised quota agreement. In the Wall Street Journal article 25 May 2018, Russia, Saudi Arabia Near Deal to Lift Output, Giving Moscow New Sway, the Saudis are seeking a modest output increase in the range of 300,000 to 400,000 b/d. The Saudis require $87/bbl to balance their budget compared to $75/bbl during 2000-2014 to support their Vision 2030 mega-projects and to insure that the Aramco international IPO is successful in 2019.

On the other hand Russian firms prefer to increase output around 800,000 b/d. According to a 10 April 2018 article in Al-Monitor, an online news service specializing in Mideast affairs, Russia Not Ready For Long-Term Commitment, the price range "sweet spot" is $50-$60/bbl because higher oil prices specific to Russian energy firms would result in the following:

  1. According to the Russian government tax structure for energy, any revenue that exceeds $60/bbl is almost fully taxable.
  2. Higher oil prices represent a disruption of financial viability for the debut of several large new energy projects coming on-line.
  3. Finally, oil prices beyond $60/bbl would benefit rival non-OPEC rivals who could capture market share.

I personally attended Columbia University Center on Global Energy Policy lecture, 22 May 2018, at the Princeton Club, "IEA's Oil 2018 - Analysis Forecasts to 2023" presented by Neil Atkinson, IEA's ‎Head of the Oil Industry & Markets Division. To paraphrase his comment on the oil market in general, "The shrinking spare capacity is vulnerable to shocks and destabilizing price spikes."

I've identified several major factors that may keep oil prices at an elevated level for the remainder of the spring and well into the fall:

From the supply side:

  1. Venezuela: production in free-fall.
  2. US shale oil: infrastructure constraints.
  3. Iran: challenge to maintain production rate without western technology.
  4. Libya: Competing rival factions need and protect oil for much needed revenue but can shutdown plants.
  5. Nigeria: Government's inability to insure steady supply vs militants sabotaging pipelines.

From the demand side:

  1. China: continued built up of strategic oil reserves.

Venezuela

Venezuela's oil production is already in freefall with an accelerated degradation of their ability to maintain oil production. It's merely a matter of time that the proverbial petro-money well runs dry. According to industry sources, it would take at least 90 days to create a recovery plan to resume any form of reasonable production. Then the hard part begins including accessing hard currency, luring back oil-service firms including technically experienced personnel, etc. - basically an undertaking of incredible magnitude. In the same aforementioned conference, Mr. Atkinson commented that the Venezuelan situation is dire with respect to its current refinery describing its capacity as "on its knees - in the single digits."

Venezuela produces about 2% world's oil however the psychological prospect of a total collapse and going off-line for an extended period will rattle the markets.

US Shale Oil

Operationally infrastructure constraints with respect to pipeline capacity will prevent the record-production of US shale oil from reaching the refineries and gulf coast for export. According to the 11 May 2018 Financial Times article US Oil Producers Battle to Meet Iran Shortfall, there are 3 major pipelines under construction: Cactus II, Gray Oak and Epic with a combined 1.9m b/d capacity which are scheduled to be operational sometime in 2019. In the meantime oil producers are using drag-reducing agents to expedite the flow of oil through the current pipelines.

Financially, US shale oil firms are still struggling to turn a profit in 2018 despite higher oil prices. According to the Wall Street Journal article 17 May 2018, Oil Is Above $70, But Frackers Still Struggle to Make Money, only 5 of the top 20 US oil companies have managed to turn a profit in the 1Q2018. The major factors for this inability to turn a profit even with higher oil prices are as follows:

  • Hedging strategies through derivatives were locked in when oil prices were in the range of $50-$55 bbl. For this reason these firms are unable to capture higher revenue of higher oil prices.
  • Considerably higher oil-field service costs such as drilling contractors and the purchase of required sand and water which have become more expensive.

These factors may result in lack of additional investments including from private equity firms as well as the exasperation of shareholders who may sell their shares for lack of better management acumen in cost control. So even when the three new pipelines are operational, the financial tap may be turned off for many shale oil firms that would ironically result in lower production despite the removal of infrastructure constraints.

Iran

The US government has yet to provide clear, concise and specific plan on how and to what extent sanctions may apply to Iran's oil industry. Even with the formal imposition of sanctions it will take many months to take effect. Iran still has strong markets in EU countries, China, India, South Korea, Turkey, Japan and Taiwan - and many of whom may not comply with US sanctions.

Nonetheless many foreign firms include shipping and oil services firms like Total are already making arrangements to disengage from doing business with Iran in anticipation of these sanctions. Iran badly needs western oil-services firms like Total which have enabled Iran to export a record breaking 2.9 million bbls last month. Withdrawal of western technical assistance will result in considerably lower future production.

From a geopolitical perspective I believe that the Iranian leadership had a contingency plan upon Trump's election victory and that it was highly likely he would fulfill his campaign promise of pulling out of the nuclear agreement. Because these sanctions will take time to implement, a savvy Iranian government can simply "wait out" Trump's remaining 2 years in office and deal with a more "reasonable" US government leadership. In the meantime, overall exports will decline.

Libya

Oil production has been erratic because competing rival factions have prevented Libya from maximizing its oil production and exports. Each faction realizes that any oil production facility under its control is a critical money-making enterprise which is why there has been little damage to the facilities themselves, merely blocking workers from entering the facilities.

According to the NY Times article 28 May 2018, Libyan Factions Agree to Elections Despite Big Divisions, the main rivals have agreed to establish election rules this September with a vote in December. Interestingly none of the rival leaders signed the agreement which puts into doubt the durability of this verbal agreement, a de facto Memo of Understanding, as the deadline approaches. For this reason, oil production will continue to be internally constrained and unlikely to increase to make up any shortfall for strong global demand.

Nigeria

This is another wild card producer and unreliable source of additional production if the quota agreement is loosened because of continued sabotage against the back-drop of an ineffective leadership under the ailing president Buhari and forthcoming elections. The oil industry has considered alternate methods to avoid sabotage by transporting oil via barges along its rivers instead of via pipeline, however the cost is 4 times higher and the barge capacity falls woefully short of what a pipeline can deliver.

China

From the demand side, China's insatiable petro-appetite as a large component of the demand side, the recently crowned largest importer of oil. At the 5th Annual Columbia Global Energy Summit on 19 April 2018, Fatih Birol, Executive Director the IEA, in an on-the-record interview with a handful of journalists, I specifically asked him about the extent to which China has achieved completing their strategic oil reserve inventory. Mr. Birol responded that the IEA estimates that China has achieved 80-85% of their inventory. This leaves 15%-20% additional spare inventory capacity for future Chinese oil purchases specifically for that purpose. Because the strategic oil reserve is of the highest security priority for the Chinese government, considerably higher oil prices will not deter them from continuing their purchases.

Recommendation

I believe that the current dip in oil prices due is only temporary in large part to the informal assurances by the Saudis and Russia for the purposes of easing market fears prior to the June 22 OPEC meeting. Additionally, it's questionable whether OPEC's loosening of production quotas will match growing global oil demand.

Because of the aforementioned scenarios, tighter inventory, several geopolitical hotpots and potential US economic sanctions on Iran, the oil market is highly vulnerable to shocks, which gives strong support to even higher oil prices.

For this reason I remain bullish on oil prices for the short and medium term with oil prices potentially bumping up against the psychological $100/bbl trip-wire.

Disclosure: I am/we are long VDE.

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.