Nobody likes making predictions, especially the weather forecasters in Colorado. Your forecast of sunny and eighty degrees made only twelve hours ago was inconveniently interrupted by a giant hailstorm slinging ice balls the size of oranges, leaving behind thousands of destroyed cars, broken windows and razed roofs.
Predicting the direction of oil prices is a hazardous endeavor, but as market observers we feel compelled to contribute our thoughts on the subject. So, with full knowledge that we might be missing the equivalent of a supply-driven hailstorm tomorrow, we will courageously don our financial rain jackets and stick our necks out with a prediction.
At an investor conference in August 2015, I gave a talk Saudi America – The Unexpected Swing Producer, and noted that Saudi Arabia and OPEC had abandoned its long-term policy of price stability in favor of market share. The U.S. shale boom had driven American crude oil production to record levels, the U.S. government had removed the shackles of the crude oil export ban and the cartel feared erosion of market share from a flood of U.S. exports. Then Saudi Arabian Minister of Petroleum and Mineral Resources, Ali bin Ibrahim Al-Naimi, instituted a price war to regain market share with the fast-growing oil consuming nations of India and China.
The price war, however, has been costly, especially to nations whose economies are heavily tied to oil exports. Al-Naimi was replaced with a new oil minister, Khalid Al-Falih, in May 2016. The fiscal pain finally proved to be too much, and as we noted on February, 21 2017 in our post It’s Happened – OPEC Re-Assumes the Role of Swing Producer, the cartel finally announced a return to its longstanding policy of price stability.
Recent market sentiment that OPEC will extend production cuts at its meeting tomorrow has driven the price of WTI near-month crude futures up by $6.00 to $51.32 per barrel today, 13% higher than the $45.52 close on May 4. But, traders are still nervous and they have reason to be.
Here’s our take:
- OPEC will announce an extension of production cuts at least through May 2018. The Joint Ministerial Monitoring Committee composed of six OPEC and non-OPEC nations, announced today their support for extending production cuts. We believe this offers a window into OPEC decision-making and is a sign the cuts will continue.
- Saudi Arabia has too much riding on a successful Saudi Aramco IPO scheduled for 2018 not to support the price stability policy. Any decline in short-term revenue will be offset longer-term by a richer valuation for its state-owned oil company. There will be no lack of bridge loans the kingdom can obtain to fill any fiscal gaps between now and the IPO.
- We may see short-term profit-taking in the days ahead. Since we anticipate that much of the production cut may already be “baked in” to crude prices, we may see some short-term selling from traders looking to lock-in gains made in the oil rally this month.
- The market is still supply-driven. Extension of the production cuts will not flip market sentiment to demand-driven. Inventories are still high, and shale production is still increasing, making it tough for growing oil demand to draw down stocks. We may still be many quarters away from the global market reaching equilibrium.
- Russia will support extension of the cuts. Russia’s fiscal budget is heavily dependent on oil revenue, and they face similar issues as the Saudis. They have more to gain from price stability than another price war.
- American shale production will continue to grow. If we have learned one thing about market economies, they are incredibly efficient at capital allocation and bringing innovation and productivity enhancements to the oil patch. So long as shale play developers can generate a positive IRR at $45/bbl, rigs will be running in the Permian Basin and other choice regions.
- Service costs on the rise. U.S. operators have so far been able to innovate, squeeze-out operational efficiencies and apply technology to increase well productivity to reduce per-unit finding costs. However, service companies are seeking to regain some of the losses they incurred in the downcycle. We hear oilfield services companies are asking for, and getting, price book increases. It’s hard to find qualified people when the rest of the economy is doing fairly well, and wage pressures are beginning to be felt.
- Crude oil prices will remain-range bound for the foreseeable future. Absent of any geopolitical event that would restrict supply, oil will likely remain range-bound in the $45-$55/bbl range for some time until there is definitive evidence that global oil stocks are in a downward trend.
Our overall thesis is that Saudi Arabia and the cartel will maintain the new price stability policy. Any move by OPEC to back away from price stability after announcing the policy change a scant three months ago would be seen as a sign of panic. Oil exporters, especially Saudi Arabia, cannot afford that to happen. Saudi Arabia will attempt to reign-in quota cheaters and do its best to soak-up the excess between now and next May.
Now, we will wait and see.