Can Russia and Saudi Arabia drive oil prices back up?

published 6 September 2016

160906-oil-prices-b — Russia could cut back on production, but would it do any good?

A mysterious message pinged into my inbox yesterday morning.

It said: "Saudi energy minister to make "significant announcement" about the oil market at 9:30am".

Now, I'll be honest with you. Much as I like to pretend I have a hotline to insiders in the oil market, the email was actually a "breaking news" alert from Marketwatch.

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Still, I was intrigued. Whatever could this significant announcement be?

A damp squib in the oil market

The energy ministers of Saudi Arabia and Russia held a meeting at the G20 summit in China yesterday. They came out of that and announced that they would work together to stabilise oil prices, "ensuring a stable level of investment in the long term".

The oil price spiked briefly from $47 a barrel to just under $49.50 (I'm using the Brent crude benchmark here).

And then it slipped back down as everyone thought: "Is that it?"

You see, it wasn't exactly earth-shattering news. Russian president Vladimir Putin had already said last week that he wanted oil cartel Opec and Russia to agree on an output freeze. In the absence of an actual agreement, anything else is somewhat anti-climactic.

The Saudi energy minister, Khalid al-Falih, then compounded things by telling one news station that an output freeze was a "favourable option, but not necessary today."

So much for big news.

Opec producers are meeting up in Algeria later this month. But the chances of coming to some sort of deal seem slim. You see, the other big problem they have is Iran. Iran is currently pumping around 3.8 million barrels a day. It reckons it can boost production to four million within two or three months.

Having just returned to the market, Iran would rather claw back market share from its rivals than cut back on production to help boost prices. So it's hard to see how an effective supply-cutting deal can be reached.

Now, you might be able to exclude Iran from the freeze, based on "special circumstance". But then, as Bloomberg points out, Nigeria and Libya will want a piece of that and why not Iraq too?

As John Driscoll of JTD Energy Services tells Bloomberg, Opec faces a "prisoner's dilemma". If they all cut back and stick to their promises, then they'll all do better in the long run. But can they trust their partners to stick to the deal, when the incentives are so skewed?

More to the point, they also still have a huge rival in the form of US shale oil. If prices go back up, US shale production becomes economic, and they all lose market share.

Add to that the fact that many of these countries are broke they can't keep up current levels of social spending without depleting their resources, but they don't want to reduce the amount of cash coming in the door, even if it's likely to help in the long run.

Where are we now in the oil investment cycle?

The Bridgewater analysts note that this is "the fourth major oil investment bust since 1900". Such cycles follow a "classic process", they say (one that'll be familiar to anyone who read Ed Chancellor's MoneyWeek cover story on gold miners at the tail-end of last year).

Bridgewater breaks it down into five stages. First you get a pick-up in demand for commodities, driven by a surge in economic growth. In the second stage, commodity prices rise, as supply can't keep up with demand. As a result, the production business becomes more profitable, and you get an investment boom.

Third, growth slows and demand fades, as high prices encourage substitution. Meanwhile, the investment boom has boosted supply. That leads to the fourth stage the supply glut. There's too much stuff, and prices collapse.

That leads to the fifth and final stage. As profit margins fall, producers slash investment and shut down production. Eventually, the market gets back into balance and you're ready to go back to stage one again.

We're in that fifth stage now obviously. But what's next?

I've turned to another interesting piece of research from Allen Brooks of energy investment specialist PPHB. Going back to 1989, he looks at drilling rig counts (the equipment used to explore for oil) and how they've fluctuated over that era.

He picks out five distinct drilling cycles (ie peaks to troughs). They don't tell you much about where oil prices might go, but they do tell that the current rebound in the rig count is among the fastest of the previous five recoveries.

What does that mean? Well, I think it'll be tricky for the oil price to rally much while there's a supply of US shale on standby, and a reluctance on the behalf of Opec to do much other than pump at record rates.

Of course, oil is closely correlated (negatively) to the US dollar's strength, which may be a factor in its favour I don't think the US Federal Reserve will be keen to let the dollar get much stronger if it can possibly help it.

So on balance, I suspect that the oil price has pretty much bottomed out. But don't expect $100 (or even $80) a barrel again in the near future.

The end of the oil era

Every one of the four oil booms has ended up unlocking new sources of supply. The first in the 1910s, "as the automobile age ushered in a new source of demand for oil" unlocked oil fields across the US. Post-World War II, new production in Russia and the Middle East came online. During the Opec price shocks in the 1970s, new sources including the North Sea arrived. And the latest boom unlocked the oil shale fields in the US.

But that initial boom in the 1910s was itself the result of crude oil replacing an earlier energy source whale oil. The price of whale oil had soared due to overfishing, creating the incentive to find an almost entirely new source.

I suspect that when we look back, we'll see that this latest oil boom finally provided the impetus needed to lay the foundations for replacing crude oil as the dominant energy source. The transition may not be imminent I imagine we might have one more oil cycle to go but in the longer run it's becoming clearer that our vehicles should end up running on something other than petrol.

Natural gas, hydrogen, electricity we're already seeing versions of all of these types of vehicle nibbling at the edges of the market. We've covered the investment implications (such as the best ways to invest With the emergence of natural gas, hydrogen and electricity the energy map is being redrawn before our eyes. My colleague Eoin Treacy believes this is a revolution one that could bring about the biggest shift in the energy markets for a century. He sees this great disruption as an opportunity, and he's uncovered a very canny way to play it. Click here to find out more.

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.