It looks like we’ve reached stalemate in the oil price wars

published 30 May 2017

17-5-30-Opec-634 — Try as it might, Opec is struggling to raise the price of oil

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.

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But now that the cuts have been confirmed, oil prices are looking distinctly droopy again.

The oil market stalemate

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?

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.)

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John 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. John joined MoneyWeek in 2005.

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.