Oil has had a great few weeks.
Between the US dollar easing, and signs of slowing supply from US shale, it’s enjoyed a massive rebound.
But how far can the oil rally go?
How the oil industry is changing
The big ‘game-changer’ in the oil market has been US shale, of course. In 2000, you’d have been laughed out of the room if you’d suggested that the US would be challenging the Saudis in terms of oil production importance within 15 years. But that’s the reality we face today.
(Incidentally, that is a useful lesson in humility for all of us who attempt to read the entrails. The unforeseeable happens a lot more often than any of us thinks possible.)
To sum up, a high oil price – fuelled partly by the ‘financialisation’ of commodities that arose from overly loose monetary policy – helped to encourage the search for new sources of oil.
Improvements in hydraulic fracturing (‘fracking’), a fringe technology, allowed reserves once deemed inaccessible to be pulled out of the ground at prices that made sense with oil at well over $100 a barrel for a prolonged period of time.
Eventually, with the Saudis pumping out oil and the US pumping out oil, fears of ‘peak oil’ faded into the background. Then the reality of China’s slowdown hit home, while a strengthening US dollar started to undermine the price too.
And the oil price finally cracked last year.
Until that point, the market wisdom – and this was universal, I cannot remember talking to a single oil analyst or fund manager who didn’t think oil had found a permanently higher range – was that Opec (Saudi Arabia, basically) would slash production to keep the price above $100 a barrel. And the idea that the price could go below $70 was madman stuff.
What happened? Well, the Saudis decided that cutting off production was really quite a stupid idea because then their customers would just queue up to get oil from elsewhere. Why should they take the pain?
This isn’t the 1970s. If Opec stops producing, there won’t be queues outside US petrol stations. They’ve got plenty of their own oil.
So, given that Saudi Arabia is the lowest-cost producer, far better to bunker down in a siege mentality and starve their opponents out.
(It’s worth understanding that when you read that Saudi Arabia ‘needs’ a certain oil price, that’s not about the cost of production – it’s about maintaining current government spending levels, which is a very different thing.)
Shale means more than just added supply
So that’s where we are today. The Saudis aren’t having fun. They’re having to borrow money and spend some of their sovereign wealth fund to close the suddenly yawning gap between government overspending and oil revenues.
But it’s having an impact. The US shale producers aren’t having a good time either. Opec’s own recent report notes that they are going to be hindered by “persistently low oil prices, highly leveraged balance sheets, and increasingly costly debt, coupled with a more cautious approach by equity investors who will limit the availability of cash”.
You can almost see them rubbing their hands with glee. And the recent rebound in the oil price suggests that they might be right.
However, it’s not that simple. Spencer Dale in the FT makes the point that the changes US shale has brought to the global oil market go beyond simply adding a big chunk of supply to the market.
The good thing (from the point of view of anyone who prefers low oil prices to high ones) about shale is that it’s pretty quick to respond to changes in the oil price. Traditional oil projects take a long time to set up and get running. It’s not easy to drill under the ocean, for example. You have to be pretty committed to the idea to get that sort of project up and running.
Shale is different. “The lead times between investment decisions and production of US shale can be measured in weeks”, not years. So that makes it very responsive. Shale techniques also keep improving, meaning better productivity and profitability at lower prices.
That’s a big change. Notes Dale: “The contraction of the shale industry that we are now observing should not be seen as a fatal blow: as prices recover, US shale is likely to bounce quickly back.”
On the flipside however, shale is a lot more dependent on the flow of credit from backers. The Saudi state oil company is not going to go bust for a want of willing investors. That’s not the case for US shale companies – in fact, they are likely to be right at the epicentre of the next wave of defaults to shake the junk bond market.
Don’t expect to see $100 a barrel of oil again soon
In all, this suggests to me that we may have seen the bottom for the oil price. But it also suggests that we won’t easily see a return to the $100 a barrel era. If shale production can kick in and get going as soon as the profits are there again, then arguably the price of oil has to be capped until – well, until someone runs out of oil.
And we have to hope that, before that happens, we’re well into the uptake of electric cars and the like.