Written on: September 14, 2017

Oil Prices On the Rise

Thursday, September 14, 2017

Energy prices rose as a global surplus of crude is starting to shrink, due to robust global demand and an effective OPEC and partners output cut strategy, despite EIA data showing another big increase in inventories and a sharp rebound in U.S. oil production. Also, counterintuitively, U.S. gasoline prices fell despite a record drawdown in inventories. Supposedly this is because the market is anticipating refineries restarting at the same time they are expecting a decline in demand due to the aftereffects of Hurricanes Harvey and Irma.

OPEC’s efforts to combat the burgeoning threat of U.S. shale oil production have been plagued by a staggering series of failures and obstacles. It’s no wonder rebalancing supply and demand, eliminating excess global inventories and achieving higher oil prices have been so elusive. OPEC’s initial strategy was to open the crude production floodgates in order to drive prices dramatically lower, with the objective of driving shale oil producers out of business. The key was that OPEC, and in particular Saudi Arabia, has a much lower cost of production than U.S. competitors. This strategy did indeed force a segment of the latter group into bankruptcy, but it also turned out that while Gulf Arab producers could cover production costs, their profit was insufficient to adequately fund their oil-dependent, high-welfare national budgets. OPEC was at risk of pushing their populations into civil unrest. The Saudi’s in particular perceived the need for a new plan of attack.

At the end of last year, OPEC unveiled a new strategy. It was focused more on price and less on market share. The initial goal was to reduce supply, which they themselves had driven to lofty levels, so that it would no longer overwhelm demand and allow excess inventories to draw down. Lower supply and stockpiles should result in higher crude prices in the vicinity of $60 per barrel, which OPEC could live with and which shouldn’t cause a robust surge in shale oil production. The mechanism for achieving reduced supply was an output cut agreement entered into by all cartel members plus several non-OPEC producers, most importantly Russia. This accord took effect in January 2017 and would last six months.

The agreement had problems right from the beginning. Several OPEC members put a massive amount of crude into the marketplace just before the cutback deal took effect, so global inventory reduction got off to a very poor start. Some OPEC countries, including Saudi Arabia, employed schemes designed to cut production without reducing exports. Some OPEC members simply failed to comply with cut commitments, such as Iraq and the United Arab Emirates. Other agreement participants simply bailed out, such as Ecuador and, most recently, Kazakhstan. It was soon apparent that rebalancing and inventory reduction goals would not be achieved by June, so the accord was extended nine months, through the first quarter of 2018.

Additional problems cropped up to thwart strategy number two. Shale oil’s breakeven turned out to be in the high $40s, so crude prices never settled out in the high $50s, because that would spur even higher tight oil production growth. Libya and Nigeria, OPEC countries exempt from cuts, saw output surge between 700,000 and 900,000 bpd in the past year, offsetting a large portion of cuts by other cartel members, targeted at 1.8 million bpd. For all of the preceding reasons, OPEC exports for January–August 2017 exceeded pre-cut agreement exports in the same period a year earlier, proving the ineffectiveness of cutback measures. In addition to supply issues, over the last two plus weeks, Hurricanes Harvey and Irma have caused significant oil demand destruction.