Oil prices, half a step is not enough

Reality is slowly dawning. Saudi Arabia has recognised that it is the swing producer in the global oil market and the only country with the ability to move the oil price by its own actions. On Monday, the Saudi energy minister Khalid al Falih announced that from August Saudi exports would be limited to 6.6m barrels a day, 400,000 below current levels, implying a net fall from a year ago, before the current Opec quota arrangement was put in place, of almost 1m barrels a day.

But is this enough to push oil prices up ? The immediate reaction of the oil market gives one answer. Prices rose on the announcement but only by 3 per cent. Brent crude crept up and just managed to reach $50 a barrel. It is worth remembering that only three years ago the price was well over $100. Any action is better than none. Without this cut in exports the price could well have fallen further. But the true answer to the question is that on its own the Saudi action is insufficient. Why? The most important factor is the trend of production elsewhere. The Saudi cuts could, and probably will, be swamped by increasing output in any one of a number of countries.

Libya, excluded from the Opec quota because of its internal problems, has a new government that is managing to get production flowing again. In June, Libyan production was up to almost 1m barrels a day. Its capacity is probably still more than 1.5m barrels a day. That level won’t be achieved immediately but there is every chance that production will rise further before the end of 2017. In Nigeria, also excluded from the cartel’s quota deal, production is increasing again. The country has offered to cap output at 1.8m barrels a day but that is still 200,000 above current levels. Russia, which never fully met its promised adherence to the Opec quotas, has every incentive to increase output and revenue ahead of next year’s presidential election, as do other oil exporters from Algeria to Venezuela. Any increase in prices produced by the Saudi action will be very welcome, but will also encourage suppliers to put more oil on the market to maximise immediate revenue.

The temptation to cheat on any quota arrangement is always high. Most important of all, US production of oil from the shale rocks of the Permian basin is set to grow by around 780,000 barrels a day by the end of the year, with more to come in 2018. Even a marginal increase in prices could push this higher as fields taken out of production when prices were low come back on stream. The International Energy Agency in its most recent outlook on the oil market into next year sees total non-Opec production rising by another 1.5m barrels a day. In their view that is sufficient to cover the projected increase in global demand. Chinese oil consumption continues to grow — imports were up to more than 8.7m barrels a day in June — but that is still being offset by flat or even falling demand in the US, Europe and Japan.

The economic boom hoped for after the election of President Donald Trump in the US has not materialised. The second downward pressure on prices comes from the overhang of stocks built up over the last three years. An unexpected drawdown of stocks in the US helped support the short-term increase in oil prices but it will take a long, sustained excess of demand over supply for stocks to return to normal levels. All this suggests that the Saudi action is directionally right but insufficient. A cut of 1.5m to 2m barrels a day will be necessary and will have to be sustained if the stock overhang is to be removed.

Only then will supply and demand be back in balance. That would be a very substantial step for the Saudis, given their internal problems and revenue needs. Optimists will judge the Saudis to be moving in the right direction, recognising reality and overcoming the humiliation of being the swing producer. Realists will be more cautious and wonder whether the new Saudi leadership will ever sanction the dramatic cut in output (and revenue) needed to stabilise the market.

Source: ft.com

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