Rumors of a possible meeting between Russia and Saudi Arabia to forge an agreement to cut oil production sent crude futures jumping late last week. Prices rose Friday, despite a sharply higher US dollar (which should have depressed prices.)
Commodities traders, desperate for any good news, latched onto the rumor despite the Russian oil minister walking back his statements Friday. He clarified that no meeting between Russia and OPEC has actually been scheduled, but that Russia would only agree to coordinate production cuts if ALL oil exporters were on board.
The rumor, which may have originated with the Venezuelan oil minister, was that Russia and Saudi Arabia would meet next month to agree on a 5% cut in oil production. A 5% cut just from Saudi Arabia and Russia would be enough to wipe out the excess monthly supply of crude, and allow record-high stockpiles to draw down.
Grasping At Straws
After being pummeled with bad news for months on end and seeing oil prices fall to 12-year lows, traders are naturally eager for some good news. Brent crude prices jumped 30% in the last two weeks of January after hitting a 12-year low, giving oil bulls some hope. However, after the rumor of a Russia/Saudi meeting was quashed, prices fell sharply.
In addition to last week's rumors, oil optimists are pinning their hopes on further stimulus by the Bank of Japan and European Central Bank to increase economic activity (which would increase oil demand.) Another factor in oil's favor is the move in China to retire coal-fired power plants and replace them with ones burning much cleaner natural gas. But these developments all pale in contrast to the record global oil glut.
OPEC Can't Stop Now
Oil was around $115 a barrel in June 2014, just 15 months ago. By OPEC's November 2014 meeting, the price was below $80 a barrel, and a price war had broken out among OPEC's own members. What happened to knock oil prices down so far, so fast?
One big reason was the explosive increase in drilling in US shale oil fields (fracking.) This transformed the US into one of the world's largest oil producers in a very short time frame. This new supply hit just as Europe and China were both experiencing economic slowdowns, decreasing global oil demand.
That slowdown, especially in China, has put not only oil, but many other commodities into a tailspin. Slowdowns in Western economies mean less demand for goods from China's export-driven economy. With manufacturing activity shrinking, Chinese demand for petroleum has withered.
A third factor in oil's sudden plunge in the last half of 2014 was a miscalculation of the effects of warfare in Iraq and Libya. Battles between the Islamic State and Iraqi government on one hand, and anti-government rebels and the Libyan government on the other, had no real effect on oil production in either country. Speculators who had driven oil prices up in expectation of reduced supplies were caught on the wrong side of the deal, and had to liquidate.
On October 1, 2014, Saudi Arabia cuts its price for oil to Asian customers. Iran and Iraq promptly followed suit. This was taken as evidence of a new price war for oil, and the markets reacted accordingly. Saudi Arabia pushed OPEC to do away with production quotas at the November 2014 meeting, beginning an effort to drive US shale and Russia oil operations bankrupt.
Like many military generals, the economic "generals" of the Arab oil states thought that victory over the frackers and the Russians would be easy, and swift. They did not count on Yankee ingenuity quickly dropping the cost of production, nor the tenaciousness of the Russians, who depended on large oil exports to survive. This oil price war has dragged on for over a year, and the smaller OPEC members are in worse shape than their "enemies" in the US and Russia.
The rich Arab oil states are dipping into their large currency reserves to fund their budgets. They have enough to continue the price war for one or two more years. They hope that this may finally be enough to deliver a knockout blow to US shale production, where defaults are expected to skyrocket when their lenders review their credit-worthiness.
If OPEC cut production now, all these months of pain would be for nothing. That is why experienced traders were skeptical about last week's rumors of a deal between Russia and Saudi Arabia to reduce output. Analysts at JBC Energy considered this rumor as OPEC trying to imitate central bankers, by using words to move the market: “At present we would judge these types of statements to be nothing more than verbal attempts to prevent the market from aggressively testing the downside,” they said.
Losing the Rose-Tinted Glasses
The OPEC oil ministers may have made a huge mistake with this price war, or perhaps they had no choice. The same technological breakthroughs that led to falling expenses for US shale producers, will let them put mothballed wells back into production in a matter of weeks if oil prices recover. This extreme flexibility when compared to foreign competitors will allow the shale companies to rapidly react to market conditions. All this together may mean that we are in a "new normal" for petroleum. Technological advances have turned many markets from a producer-controled market into a demand-driven one. For example, aluminum used to be more expensive than gold, until technological advances made it easier to separate from the ore. This is much like how the shale industry has cut expenses by an average of 50% in the last two years by using new fracking technology.
With high oil prices likely a distant memory, the Persian Gulf monarchies are caught with economies almost totally dependent on the oil trade, and shrinking amounts of money to continue staving off social unrest. It seems that the losers in the long run may be OPEC itself.
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