Can OPEC cap production and prop up oil prices?

The latest jolt to the always volatile oil markets: Talk coming out of OPEC about a possible move to tighten supplies, which has set off a bit of a rally in crude prices. But does the talk add up to much? And are there any other reasons to bet on (or against) a longer-term upward move in oil?

An OPEC Production Cap. Maybe.

One of the biggest subplots to the recent swoon in oil prices has been OPEC’s seeming inability to prop up prices by getting excess supply under control. Historically, the group would act to rein in its production when global oil markets were oversupplied, and open the taps when world oil demand was climbing. But when OPEC announced in November 2014 that it wouldn’t curb output in response to falling prices, the decline became a rout. Since then, the cartel has seemed either unwilling or unable to cut output, probably out of fear that producers in the U.S. and elsewhere would take advantage by pumping more and stealing OPEC’s market share.

Last week brought a glimmer of hope for oil bulls looking for OPEC to act. Member nations Saudi Arabia, Venezuela and Qatar joined nonmember Russia in a proposal to collectively cap production at current levels. So, not a cut, but a possible first step toward one later, right?

But the proposal to cap output comes with key caveats. First, the Saudis and their colleagues said the plan depends on other big exporters, such as Iraq and Iran, getting on board. Winning over Iran seems to be a tough proposition. The recent end to Western oil sanctions against the country has allowed Iranian oil to flow more freely again, and Iran has announced its intention to ramp up exports to take advantage.

Reaching an agreement and sticking to it will be hard. Will Iran do an about-face and agree to hold exports in check after enduring years of punishing sanctions that are finally gone? Especially when doing so requires cooperation with archrival Saudi Arabia? We’re skeptical, and we’re not alone. OPEC “will freeze [oil output] when I see icebergs floating in the River Styx,” says Stephen Schork, editor of energy market newsletter The Schork Report.

What’s more, even if OPEC does cap production, that’s a far cry from what’s needed to really bolster oil prices. Capping output at today’s booming levels would ensure that supply continues to exceed demand for months to come. At current supply and demand levels, the International Energy Agency expects global stockpiles of stored crude to increase by 285 million barrels over the course of 2016, on top of the billion barrels added during 2014 and 2015. That calculation suggests that the world’s daily oil output needs to fall by close to 1 million barrels to stop adding to already swollen stockpiles.

A Silver Lining for Bulls

Color us skeptical that OPEC is ready to ride to the oil market’s rescue. We have said before that the cartel might eventually act to cut (not cap) production, but only if prices fall sharply enough to convince Saudi Arabia and Iran that joint action is preferable to even more financial pain.

But there is some reason to believe that global oil production will eventually slow. You’ll find it happening in Texas and North Dakota, not the Middle East. Precisely tracking the amount of oil produced in the U.S. every day is notoriously difficult, but the Department of Energy’s weekly reports are pointing to a downward trend. Over the last month, DOE’s tally shows daily U.S. output fell by 100,000 barrels.

Admittedly, it’s probably too soon to declare that domestic production is really starting to wane. After all, many forecasters (Kiplinger included) expected production to take a bigger hit than it did in 2015. The price slump caused a sharp drop in drilling activity, raising expectations that output would soon follow. But after hitting a peak of about 9.7 million barrels in April of last year, daily production saw only a slight decline. Even though operators were running fewer rigs, they were scrambling to pump more oil from each well they did drill. That improvement in efficiency helped keep many in business, and also prevented nationwide output from falling very much.

Perhaps the U.S. industry has reached a tipping point, in which improvements in drilling efficiency are no longer enough to compensate for so few new wells being drilled. If so, total output might decline by enough to really put a dent in the worldwide supply glut. Even if that plays out, the U.S. would remain a production powerhouse. But taking a few hundred thousand barrels of daily output off the market would do a lot more than any OPEC production freeze to boost crude prices.

Still, any price rebound is going to take time. Both around the world and in the U.S., storage tanks keep filling up with crude and refined products. Since the start of the year, crude stockpiles here have jumped by almost 22 million barrels and now stand at their highest level on record in DOE data going back to 1982. Gasoline in storage is also at a record high, suggesting that demand from motorists isn’t exactly robust at the moment.

If storage tanks get much fuller this winter, oil prices could take another step down. We tend to think such a decline would be brief, because it would almost certainly idle even more drills and cause production to shrink faster. But for an industry that’s already suffering from low prices and struggling to secure credit from lenders, even a short-term plunge would be extremely painful.

A Note on the Clean Power Plan

A number of readers have recently asked about the outlook for the Environmental Protection Agency’s Clean Power Plan, which aims to require electric utilities to cut back their emissions of carbon dioxide. The Supreme Court took the rare step of ordering a halt to the regulations while it waits for the opportunity to rule on their legality. And now, with the death of Justice Antonin Scalia, the fate of the plan is even less certain.

In our next issue, we’ll be looking at the CPP’s legal status and its odds of being implemented as written. While the gyrations in the oil market demand attention, it’s only one of many big stories playing out in the energy world so far in 2016.

 

Will Google’s home internet come to your town? … plus other tech news

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Guess which industries aren’t happy about cheap oil

It’s impossible to miss all the headlines these days about the crash in energy prices and the damage it is doing to the balance sheets of firms in the oil, gas and coal businesses. But the ripples from the price plunge extend beyond the coal miners and ExxonMobils of the world. A slew of industries tied to the energy world are also suffering, with little relief in sight.

Off the Rails

Few sectors of the economy benefited more from the surge in U.S. oil production than freight railroads and their suppliers. With so much new crude coming out of the ground (often in parts of the country not connected to oil pipeline systems), rail suddenly became a critical conduit for linking shale fields in the interior to the nation’s coastal refineries. Moving crude by rail costs more than moving it by pipeline, and derailments have sometimes led to catastrophic accidents. But oil trains can go where pipelines don’t, and they give refiners the flexibility to source crude from different suppliers as prices fluctuate.

Now, not so much. Slipping oil output in North Dakota means less demand for the rail tanker cars that were needed to haul crude from the Bakken Shale to market. Meanwhile, with new pipelines coming on line, less of the state’s output is traveling by rail. From a peak of more than 800,000 barrels per day hauled by rail in December 2014, producers in the Peace Garden State now rely on oil trains to haul slightly more than 500,000 barrels per day, according to statistics from the North Dakota Pipeline Authority. Nationwide, the number of railcars carrying crude and refined products has fallen from a peak of about 16,000 in mid-2014 to fewer than 13,000 today, according to the Association of American Railroads.

And it’s not just fewer tanker cars riding the rails. Less drilling means less need to haul drilling equipment, supplies and materials to job sites. Which helps explain why freight railroads in January saw a 10% year-over-year drop in shipments of crushed stone, gravel and sand, a category that includes the sand used by the oil and gas industry in hydraulic fracturing. (More on sand miners’ woes later.) Meanwhile, the huge drop in coal burned to generate electricity that we’ve noted in the past is also affecting railroads, which are moving far less coal than they did several years ago.

It all shows up on railroads’ bottom lines. Union Pacific, for instance, reported a 19% drop in operating income for the fourth quarter of 2015 compared with a year earlier. Even though UP hiked its freight rates, and even though cheap diesel fuel helped cut costs, the decline in freight volumes still dragged down earnings. Until the economy shows more pep and steams up demand for shipping of consumer goods to offset the weakness in commodities hauling, we don’t see much bounce for rail freight volumes.

Sand Storm

Low oil and gas prices spell less drilling activity. And less drilling activity means less demand for a basic ingredient in fracking: Sand. Energy firms inject many tons of round grains of sand down their wells to prop open the cracks in energy-bearing shale and other rock layers that fracking opens up. The surge in drilling activity in recent years has been a boon for companies that mine the grades of sand that energy companies favor.

But now, with rig counts dropping and sand usage falling, those miners are under intense pressure. Hi-Crush Partners, a major frac sand producer based in Texas, is shedding workers and cutting other costs to cope with falling sand prices and demand. The company, organized as a master limited partnership, has nixed its dividend to conserve cash as its unit price has slumped from $40 last spring to about $5 today. My colleague, Jeff Kosnett, who edits Kiplinger’s Investing for Income, says that investing in sand producers is far too risky given the weakness in oil and gas prices and the stress that sand miners’ customers in the energy business are under now.

There is one bright spot for frac-sand, though: Energy firms are using more of the stuff in each well they drill because doing so results in more oil and gas output per well. That’s not enough to keep demand from falling right now, but eventually, when energy prices rebound and drilling activity perks up, it should bode well for the miners that can survive the current downturn.

Construction Woes

The downturn in the price of oil, gas and many other commodities also hits makers of the machinery needed to dig the stuff out of the ground. Perhaps no company better illustrates this trend than Illinois-based Caterpillar, which saw revenues tumble by 15% in 2015 from the previous year. CEO Doug Oberhelman says that the company’s energy and transportation division, which includes the company’s sales of products to the energy industry, saw new orders drop by 90% last year.

Cat doesn’t see things turning around in 2016, either. The company projects that revenues will drop an additional 10% this year because of weak commodity prices that are weighing on its customers in the commodity world, and because of slowing growth in key emerging markets such as China. Other makers of earthmoving and mining equipment are probably sweating the same worries right now. Indeed, many emerging markets (think Brazil, Australia, South Africa, etc.) are geared heavily toward mining or energy production, or both. Don’t count on any of them to be ordering many bulldozers or backhoes anytime soon.