A couple of weeks ago, oil producers of the world decided to do “whatever it takes” to “rebalance” the oil market.
In other words, they are worried that prices are getting too low, and so they wanted to cut back production to make sure they don’t fall any further.
At first, the market took the bait. Oil prices bounced strongly as oil cartel Opec and big producer Russia announced plans to extend production cuts.
But now that the cuts have been confirmed, oil prices are looking distinctly droopy again.
The oil market stalemate
At the end of last week, Russia and Opec agreed to extend oil production cuts until next March. Contrary to expectations, Opec and co (24 nations in all) not only agreed production cuts, but over the past six months or so, they’ve actually stuck to them.
That’s unusual. Normally, you get a fair bit of “non-compliance” – everyone stabbing each other in the back as they take advantage of lower competition from their rivals.
So they’ve been very well behaved this time around. Has it helped? Not really.
The market was unimpressed overall. Prices in the US dipped back below $50 a barrel. It’s partly because the news had been expected. But it’s also because investors are waking up to the fact that Opec can only do so much.
“While stockpiles are shrinking”, reports Bloomberg, “ministers acknowledged the surplus built up during three years of overproduction won’t clear until at least the end of 2017.”
Here’s the fundamental problem for Opec members and any other country whose economy has been relying on eternally high oil prices to keep them afloat: US shale oil.
Opec got careless and greedy, as everyone does during the good times. While most other countries were struggling after the 2008 financial crisis, oil producers were doing just fine. Oil at $100 a barrel looked like a nice round number. The price had stayed above that number for so long. Why not take advantage of it?
But the problem was, at $100 a barrel, it made lots of sense for any small producer with ambition and a patch of shale to have a crack at getting it out of the ground. Better yet, with interest rates at near-0% (as a direct result of said financial crisis), there was nothing stopping them from raising the funds to do so.
If oil prices had fallen early enough during the shale discovery process, then the industry could have been killed off, no doubt about it. If oil had gone back down to $20, or maybe even $40 a barrel, a good while ago, then it’s possible that US shale producers would have given up.
But eventually, a tipping point was reached. Money was riding on projects being successful, and others had gone past the point of no return. So even when oil prices fell, it made sense to continue pumping out oil to generate cash to repay interest on loans.
With margins being squeezed, it made sense to ramp up investment in technology in order to improve the break-even point. And with shale producing excitement, jobs and growth – not to mention the idea of energy security – in an otherwise troubled economy, it became politically important too.
So Opec allowed an industry to grow right beneath its nose, and it’s now too significant to be killed off.
As Eoin Treacy puts it on FullerTreacyMoney.com, “US onshore unconventional supply is now an important global swing producer and is economical around $60”.
What does this mean for investors?
What does it all mean? Well, as I said the last time, Opec’s willingness to curb production is a good sign. The current deal encompasses countries that “pump roughly 60% of the world’s oil”, notes Bloomberg. So if they remain disciplined, then the oil price is unlikely to collapse.
I imagine we’ll also see a lot of central-banker-style “jaw-boning”, with Saudi Arabia in particular, acting to talk up the market any time it looks as though prices are going to slide.
But at the same time, if you’ve got shale oil producers ramping up production, then it’s hard to see how prices can go a lot higher. The number of rigs in use in the US bottomed out a year ago almost to the day.
Now they’re climbing steadily – the week before last saw the 19th week in a row of gains – and that’s unlikely to slow down if US shale producers believe that Opec is now keen to put a floor under the price.
So for now, let’s assume that oil prices are stuck in a rough range. They might not drop sharply, but it’s hard to see a scenario in which they rocket higher either.
In terms of the bigger picture, less volatility in the oil price is a good thing for the global economy. As a consumer country, we like cheaper oil. The producers might not be so happy, but if oil is roughly where it is, they can mostly get by.
As for investors, oil companies that made it through the carnage of the crash are probably more comfortable now with prices around where they are now (or preferably a bit higher). A much bigger concern just now, of course, is the furore surrounding oil services giant Petrofac – but we’ll have more on that in MoneyWeek magazine this week. (If you’re not already a subscriber, sign up here.)