Latest oil deal should boost price above $50, but not much more
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Nervous markets this week welcomed reports that OPEC and other major oil suppliers, including Russia, plan to hold back production for an additional nine months to stabilize prices. The alternative was to abandon the pact, pump more oil and see prices tank for all producers. This was the “lose-lose” option. However, let’s not get too excited and think prices could reach and sustain $60 a barrel anytime soon.

It can never be exactly clear what combination of motives is driving forward this cut in production. We do know that many of the producing countries are excessively dependent on oil to balance their national budgets. They know that, as difficult as current conditions may be, the alternative is worse. Saudi Arabia has the added incentive of bringing a Saudi Aramco initial public offering to market in several months. A collapse in prices would make that very difficult.  

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Meanwhile the drilling rig count and oil production in the Permian Basin in West Texas continues to grow, making the U.S. the world’s largest oil producer. Companies that have been able to avoid or reschedule excess levels of debt have survived the crash. They found more efficient ways to operate — focusing on so-called “sweet spots” and reducing the time it takes to drill a well. With the “shale play” increasingly a manufacturing operation, these operational improvements become embedded. 

 

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The reason OPEC and “NOPEC” (the oil-exporting nations not in OPEC) have had to take these steps is because world demand was sluggish just as U.S. production surged. In “normal times,” global demand could be counted on to grow each year by about one million barrels per day. With slow recoveries in the U.S. and Europe and slower growth in China, that isn’t happening.

On the supply side, companies invest to replace reserves they deplete each year. For several years this combination of supply constraint and market growth held the market in balance. 

Oil is a commodity and is subject to the pressures of the market. A small imbalance — surplus or shortfall — has much more than a proportional impact on prices. Oil markets had a surplus of 1-2 percent in 2014, but that knocked prices from over $100 a barrel to the $30s until price recovery began several months ago.

The bottom line for the market is the inventory of produced oil, which is stored around the world. Although the data isn’t perfect, analysts keep a close eye on this as an indicator of near-term price movements.

The medium-term price prospects are fairly robust, in no small measure because companies have slashed capital budgets dramatically since the crash began in late 2014. With lead times of three to five years (or more) to produce from new fields offshore and in other challenging areas, today’s lack of investment translates into future tightening of supply.

Added to that is instability in some producing countries. Venezuela’s PDVSA is teetering on defaulting on billions of dollars in debt. Its creditors are circling its subsidiary, Citgo, with three refineries and other assets in the U.S. Recent reports suggest that a forced sale of Citgo would not be able to satisfy immediate creditors, who run the gamut from Rosneft in Russia to ConocoPhillips. 

Russia continues to produce substantial amounts of oil despite U.S. and EU sanctions, but with restrictions on the export of technology, that will be under pressure in the medium term. Nigeria has been problematic for some time and is no less so today. 

If OPEC/NOPEC formalize the agreement to withhold oil from the market for an additional nine months, oil markets may stabilize in the low $50s, but fundamentals need to be watched very carefully and expectations tempered.

 

Bill Arnold is a professor in the practice of energy management at Rice University’s Jones Graduate School of Business. Previously, Arnold was Royal Dutch Shell's Washington director of international government relations and senior counsel for the Middle East, Latin America, and North Africa.


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