I had no intention of this oil discussion turning into a running series, but it has because the oil price plunge has been a fascinating chess game to watch unfold. Previous posts on oil can be found (in order) here, here, here, and here. Today, there are two points I’d like to talk on. Now, to the Batmobile!
I recently came across an interview with the Saudi oil minister Ali Naimi that took place in mid-December. The interview (not to be confused with the terrible movie of the same name) is confirmation of exactly the strategy I proposed in my original oil post, this time coming straight from the Saudi’s mouths. The full interview is a good read, but I want to pull a few key quotes from it. In my original post on oil, I proposed that OPEC wouldn’t cut production purely because that was the most logical business decision for them; then normal market forces would take the reins from there. Since then, and now with everyone and their mother on the oil talk bandwagon, there’s endless conspiracy theories being thrown around about the US trying to hurt Russia, ISIS flooding the oil market to hurt the US economy, etc. Reality is much simple than that.
Will Saudi Arabia not cut production if the Russians do not cut?
First of all, why did we decide not to reduce production? I will tell you why. Is it reasonable for a highly efficient producer to reduce output, while the producer of poor efficiency continues to produce? That is crooked logic. If I reduce, what happens to my market share? The price will go up and the Russians, the Brazilians, US shale oil producers will take my share.
It is also a defense of high-efficiency producing countries, not only of market share. We want to tell the world that high-efficiency producing countries are the ones that deserve market share. That is the operative principle in all capitalist countries.
This was exactly my point from day one. There is no grand conspiracy. Why would OPEC cut production to bolster prices when higher prices will favor the marginal fracking operations in the US and Russia?
If the price remains at roughly $60/B the call OPEC crude will be 2mn B/D less than current output. If OPEC production does not fall by 2mn B/D, is there some point within the coming year at which OPEC would have to take the decision to cut?
I want to make one thing clear. It is unfair of you to ask OPEC to cut. We are the smallest producer. We produce less than 40% of global output. We are the most efficient producer. It is unbelievable after the analysis we carried out for us to cut.
If the price falls, it falls, you cannot do anything about it. But if it goes down, others will be harmed greatly before we feel any pain.
Venezuela needs a higher price than you
That is true, but that is not of any use. But all we will do if we allow prices rise as we did in 2008 in Oran [is to raise] the production of marginal barrels. This was less than 1mn b/d [in 2008], today it is around 4mn b/d.
Has that point been sufficient reinforced? No conspiracy. No Russian punishment. Turn off the idiots on CNBC. OPEC is on the same page that I was on when I presented what I believed would be their strategy in my original post. It’s simply wise business people looking out for their own interests by making good business decisions.
With that clear, we come to my second talking point. Anyone that’s watched CNBC or read any so-called “expert” analysis has surely heard about this oil glut we have. Supplies are just through the roof and demand is nearly at zero. That’s why we have such low oil prices… except it’s not. In fact, I find this hilarious. As recently as six months ago, we were talking about surging demand in developing markets driving world demand skyward.
The conclusion, as recently as last July?
The story of oil in 2013 was one of surging US production and increasing demand in developing countries. The US continues to lead the world in increasing oil production, while developing countries — in particular the Asia-Pacific region — have added the vast majority of oil demand in recent years. Arguably the only thing preventing the world from experiencing oil prices in the $150-$200/bbl range is the continuing shale oil boom in the US.
Yes, that’s right, $100+/barrel was not only reasonable given the supply/demand outlook, but we were barely holding off $150-200/barrel prices. That was in July. Last July. So what’s changed since July? Nothing.
Worldwide crude production increased 1.5% from Q2 to Q3 in 2014. A whopping 1.5%. Demand only increased 0.005% during that period, so let’s just say it didn’t increase at all. In Q4 of 2014, demand actually up ticked almost enough to meet production, while production only increased 0.00011% between Q3 and Q4 2014 (per above chart)… yet this is the period of the most drastic plunge in oil prices. There was virtually no change in the oil market between the time people were justifying $100+/barrel oil and the time people were calling for $20/barrel oil. So what gives? Oil is now worth less than half of what it was six months ago. Where are the fundamentals to support this drastic price swing? They don’t exist. Everyone is talking like they exist and “oil glut” is the new buzzword, but where’s the evidence?
Yes, there is a relatively small production surplus and it is predicted to grow into the first half of 2015, but we’re talking about a 55% drop in oil prices NOW. The current surplus does not account for a 55% price swing, especially when considering the impending drop in marginal well production at the new, lower oil prices. The facts just don’t agree with the narrative. That leaves us with two possible conclusions: oil was grossly overvalued in the summer of 2014 or oil is grossly undervalued today. If you believe $108/barrel was a reasonable oil price, then the only conclusion you can come to is that oil is currently grossly undervalued. If you believe oil’s current price is reasonable, then you can only conclude that it was grossly overpriced in July 2014. At the time, oil prices of $100+/barrel last summer were justified on the speculation of future shortages (that never panned out). Today we have the opposite. We have a massive plunge in oil prices based on the speculation of future surplus (but will it pan out?). What do those two explanations have in common? Speculation and no basis in our current situation. Lay people often joke about how fickle oil prices are and how they drastically increase seemingly with as little prompting as a change in the wind direction. There’s actually truth to this. I know it’s cliché to blame traders for commodity price swings, but unfortunately it’s also completely accurate. Fundamentals are an afterthought when it comes to prices of equities and commodities traded on the open market these days. Big money plays with the market to create profitable trades and then the “analysts” at CNBC and elsewhere swoop in long after the move to cherry pick fundamentals to mold into a false back story they can sell us on why the price change happened. Any event can be used as an excuse to drive prices up or down by completely unrealistic amounts (relative to fundamentals) in an attempt to make money. This is a fact that’s lost on the average American (like so many facts), but, funny enough, is not at all lost on the Saudi oil minister.
Were you taken by surprise by how much [the price of oil] fell?
No, we knew the price would go down because there are investors and speculators whose job it is to push it up or down to make money.