July 7, 2017

Range-Bound Oil Markets Still Gushing

Oil prices remain stable (for now), but their historical propensity to reach for the clouds (or mope in the gutter), is stronger than ever. 

The market for hydrocarbons has never been so tense, as it is today.

Crude oil prices have swan-dived from their lofty peaks in 2008, down to generational lows today. Not only that, but the threat of other energy sources and political dog-fighting between rival industrial nations doesn’t help to keep oil market tensions contained.

Crude oil is the lifeblood of modern economies, especially the industrially developed nations such as the G20. Without cheap oil, entire manufacturing lines come to a halt, people cannot get around, businesses stop investing for the future and prices for all sorts of goods tend to rise. The fact remains that crude oil is a key component in a wide variety of industries such as plastics, clothing, cosmetics, chemicals, agribusiness and many more.

With oil being so pivotal, one would think its long-term viability as a commodity would be safeguarded and protected. But instead, the crude oil market has been squabbled and scrapped over by a host of both producer and consumer countries — with the only thing being safeguarded is the nominal price level of each barrel of oil.

Cartel by Name, Cartel by Nature

The oil industry operates under an admitted oligopoly in the form of OPEC. OPEC is a cartel comprised of the major oil producing countries — and its job is to keep prices “stable”. This is done by artificially adjusting the amount of oil sold to market, sometimes several months in advance. Keeping prices within producer-desired ranges is good for producers, but not necessarily so for buyers.

When prices are kept artificially low, this is a boon for oil consumers such as the US, China, Japan and the EU. But when prices rise, it is oil exporting countries such as Russia, Venezuela, Saudi Arabia that benefit most.

There is however one country that is walking the path of optimising both producer-led, and consumer-driven effects upon oil market dynamics — the United States.

Over the past decade, the US has kickstarted an oil production avalanche courtesy of fracking, better distillation and better storage facilities. What’s been dubbed as the ‘Shale Gale’ — a storm of US-sourced oil natural gas production — has also seen oil production ramped up beyond the wildest imaginations of bullish analysts.

The US is now producing more oil every day (10 million barrels), then it did back in the early 1970’s. This fact alone is rather extraordinary, considering that oil fields gradually lose their flow rate potency over time, and oil prices have been incredibly volatile in the interim — rising as high as $200pb in 2008, but languishing as low as $40pb last year. In relative terms, oil prices are closer to historic lows, rather than their highs.

What’s even more extraordinary, is that the boost in US production since 2008 has been parabolic— a moment of history famously scarred by the Global Financial Crisis (GFC).

In some respects, the US has leveraged oil production and oil exports, to slingshot its way back to economic prosperity. Low oil prices have been a consistent fixture of international markets over the past few years, and most G20 countries would rather like this to continue.

Crude oil prices have been resoundingly range-bound, between a high of $60pb and a low of $40pb since 2015.

Considering the effect of an increase in US production — how does this affect the rest of the world?

The impact of hydraulic fracturing (fracking) upon society in general is highly controversial, but its impact on oil supplies (and prices) is undisputed. A frenzied rush into fracking by US oilers, has led to huge increases in oil inventories and oil stockpiles in both the US and elsewhere.

Other globally-important producer countries have also started to increase production, primarily to secure domestic supplies and to reduce dependence on imports:

The above chart should be ringing some bells (and inducing a mild case of déjà vu) because the primary producers of oil, also happen to be bitter geopolitical rivals in pretty much all sectors and industries. Also bear in mind, that fracking has not been utilised by countries other than the US — once they do, it would likely mean an even higher rate of supply.

By far the biggest gainers in terms of oil output have been the US and Russia since the 2000’s — in fact, Russia is now the largest nominal producer of oil, pipping Saudi Arabia into 1st place (although Saudi Arabia has larger aggregated Reserves).

If looking into oil prices and production trends, there is one cornerstone factor that continues to influence prices and supplies, more than any other: The Organization of the Petroleum Exporting Countries (OPEC).

The OPEC Effect

As an organisation (and de-facto cartel), OPEC seeks to artificially manipulate oil prices, for the benefit of its members.

Just recently, OPEC and a splinter group of non-OPEC members have agreed to cut production by 1.8 million barrels per day, until the end of the Q1 2018. At the last OPEC gathering, Saudi and Russian officials pledged to “do whatever it takes to balance the market”. In other words, as leading suppliers of oil to consumers, Russian and Saudi Arabia pledged to move prices higher, out of the $40-$60 range.

On multiple occasions in recent years, Russian policymakers have admitted that Russia’s balance of payments breaks even when oil is at $60pb. If it languishes below this price for too long, Russian foreign exchange reserves begin to be depleted as its central bank starts to feel the pain of large capital outflows.

On an annual basis, OPEC members will produce around 60-80% of the world’s oil, but not every oil producing country is an OPEC member. This has often created economic tensions and caused political strife between neighbouring countries, and yep you guessed it, created knee-jerk oil price volatility.

Summing up the somersaults in Oil market dynamics

The oil market is a hugely entangled beast with a huge amount of dynamically interconnected factors that include economics, politics, geopolitics, finance, shipping, storage, financial derivatives, industrialisation and even the weather.

To sum up the only winners from all the hullabaloo in oil, take a look at the chart below, showing the change in ‘open interest’ in crude oil futures as recorded on US derivatives exchanges, such as the Chicago Mercantile Exchange (CME) and Chicago Board of Trade (CBOT).

Open interest simply refers to the number of open contracts that have yet to be closed or settled — and serves as a superb barometer for the amount of speculative market activity in any market.

As you can see, open interest is rising steadily…

So, as oil prices continue to remain stable (for now), their historical propensity to reach for the clouds or mope in the gutter is seemingly stronger than ever.

Speculators, lock and load.

Written by George Tchetvertakov