Oil Prices - What’s On Producers Side
Recent efforts to put a cap on oil production in an attempt to balance the market, has not affected the pricing trend. Energy ministers from Saudi Arabia and Russia, the two major oil producers, accompanied by colleagues from Qatar and Venezuela failed to reach an agreement to cut production, compromising only on introducing a limit, fixing the output at mid- January level. With this diminishment of the original intentions, the agreement had no immediate impact on prices: curves stayed almost unchanged. The market, psychologically eager for a price adjustment, was disappointed by the modesty of the bargain.
All eyes were on Iran, which enjoyed being sanctions-free and was looking to increase his oil production and sales, seeking cash-flow, investments, and modernization. Iran did not promise to limit its production to the agreed level, but said to support the move.
However, the Russian-Saudi joint initiative should not be viewed in a short-term perspective. The impact of an unexpected concordat could prove itself later and apparently both countries have an understanding on the long-term consequences. The initial goal seems to be to send a clear message to the market that the two biggest producers perceive that something should be done, in the present dire state of sales, on the producers’ side. Combined with other factors, the mutual concessions could set the stage for the future correction of prices through the rebalancing of supply and demand.
The most important of these factors is the underinvestment in the oil industry, counting from 2015 (-24%). For the current year, the forecast adds another -17% to the investment allocations. The International Energy Agency is worried that it’s the first time, since 1986, that the investments in the oil sector are lowering uninterruptedly for two consecutive years. It is an assured path to production slowdown, whatever political decisions could be adopted to prop up the industry.
The tonality of comments by the energy Ministers of both Saudi Arabia and Russia are suggesting that they are playing the mid- and long term strategy, not expecting immediate results.
Mr. Ali Ibrahim al-Naimi, Saudi Arabian Minister of Petroleum and Mineral Resources, said while in Huston that he was not willing to strike a deal with other producers on production cuts, because nobody would respect it. However, the freezing of the present output levels is a step in the right direction in order to balance the market. In his opinion, with a price of $100 a barrel producers of unconventional oil, shale oil are inclined to invest heavily and flood the market.
Mr. Alexander Novak suggested in an interview that $50 a barrel would perfectly satisfy producers and consumers. From his perspective, even if Iran does not limit its production to the mid-January level, it will not have an impact on the global supply because producers responsible for 75% of oil output are keen to support the Russian-Saudi agreement.
The main problem in that supply and demand is not the only influencers shaping oil prices. Geopolitics is one more contributor to the hanging uncertainty. Plus the total financialization of the oil market (oil is no longer only a commodity, it is a financial instrument of choice), and this could be the most valuable element in the equation.
Looking back at the evolution of oil prices, up to mid-2004, they were fluctuating around $40 a barrel. In 2006, they went up to $60 and then peaked at $147 in July 2008. At the end of the same 2008, they were down to $30, but in 2011 they once again reached $110. From September 2014 up to now, they dropped to the current level of around $30.
The high price volatility does not at all correspond to the real global oil supply and demand equation. The global extra supply is barely 1/100 of the consumption level, but the prices have lost almost ¾!
Apart from a pure speculative aspect with big players betting on a low oil price, there are some objective factors pushing the prices down.
The strategy of Quantitative Easing (QE) was used by the US Federal Reserve to provide the economy with cheap money and to pull the economy out of the crisis, which started in 2008.
The US economy rebounded; however, growth was very modest compared with the enormous amount of freshly printed paper money. The enlarged monetary mass didn’t affect production or consumption, it remained revolving mainly in the financial sector thus providing opportunity for those who know how to make money out of money. The FED cancelled QE in December 2015 but the European Central Bank, the Bank of Japan and some other regulators are going on with their own QE programs.
These huge amounts of money are not contributing to the economic recovery: the consumers’ and corporate demand for loans and credits is not there, especially with deflation expectation is some of the free market zones. The “new” money remains in the financial turnover, including the oil market, and does not contribute to revitalizing production. As a consequence, the growth in the EU, Japan, etc. remains anemic; forecasts claim there would be another slowdown in US, and further on in China. It does not help oil prices to stabilize and contributes to the present uncertainty.
Another important element is the high level of debt of energy corporations. When oil prices were high they’ve accumulated enormous debts using loaned money for investment purposes. From 2006 to 2014, the indebtedness went up by 13% a year on average, from $600 billion to $1,600 billion. Their obligations emission, in the same timeframe, was up by 15% y-o-y, from $455 billion to $1,400 billion.
The impact of the low price trend is dramatic. The capitalization of energy companies is down, as well as profits while risks of insolvency soared. Oil industry lacks liquidity and keeps pumping to provide cash-flow, simultaneously contributing to overproduction and further sliding of prices. Finally, deals with oil futures are multiplying, and it saturates the market with paper oil and pushes the price further downward, in full conformity with the rules of commodity exchange speculative mechanism.
There are no efficient solutions on offer to rectify the distortions in the financial and energy sectors. Until this challenge to global economy is properly addressed, the current situation of instability and unpredictability on the oil market, uncomfortable for producers and also for consumers, will persist.
The views and opinions expressed in this article are those of the author and do not necessarily reflect the position of ESCP Business School.