A tentative deal by OPEC to reduce its oil production sparked an early autumn rally in crude oil prices. But now, with rumblings of internal dissent within OPEC, that rally has stalled. Can the oil market recover its recent momentum? Or should oil bulls prepare for yet another downturn?
OPEC to the Rescue?
Oil prices were climbing swiftly this spring after bottoming out at about $26 per barrel in the depths of winter. Benchmark West Texas Intermediate had just crested the psychologically important $50-per-barrel level in late June when British voters shocked the world by opting to depart from the European Union. The ensuing upheaval in financial markets knocked WTI back down to $40 per barrel, halting the rally in its tracks.
Then came an announcement by OPEC in September that the oil exporting cartel was joining forces with Russia, a nonmember and one of the top oil producers in the world, to jointly cut their production in a bid to reduce excessive supply and push oil prices higher. Traders seized on the news and promptly bid WTI back up to $50, erasing the post-Brexit slump in less than two weeks.
So is the rally back on track? I remain skeptical.
First, consider the factor that pushed crude oil prices down from $100 per barrel in the summer of 2014 to $26 per barrel in the winter of 2016: Excess supply. Prolific production gains in the U.S. brought new barrels of oil to market at the same time economic growth in China and other big oil consumers was downshifting. The result: A price rout. Even with this autumn’s recovery to $50 per barrel, the price of oil still reflects a world with too much supply and not enough demand.
Stockpiles of oil remain hefty. In the U.S., the world’s number one oil-consuming nation, stocks of crude and refined fuels total 1.34 billion barrels, up from about 1 billion in early 2014, back when oil traded closer to $100 per barrel. Today’s level is just a hair below the all-time record of 1.37 billion barrels set this summer. Meanwhile, the International Energy Agency reports that stocks around the economically developed world total 3.1 billion barrels. Without a cut by OPEC, the IEA reckons that those stockpiles won’t decline enough to balance the market for another year or so.
In short: OPEC needs to curb production to lift crude oil prices. But can it?
Let’s Make a Deal. Or Not.
We won’t know the answer until the group meets in Vienna at the end of November and issues a formal announcement on its production intentions. But actions can speak louder than words. And OPEC’s actions lately don’t signal a meaningful production cut is imminent. In fact, the group’s combined oil output set a record high in September, thanks to strong production by Saudi Arabia and other members in the Middle East. “The more they talk, the more oil they put out on the market,” notes Stephen Schork, editor of energy investing newsletter The Schork Report.
Cutting back from its record-high output could be even harder for OPEC because several of its members will reportedly not be required to contribute to the cuts. Libya and Nigeria are apparently exempt because both are struggling to restore production in the wake of terrorist attacks or civil war. Likewise, Iran won’t be on the hook because its exports are still recovering from economic sanctions imposed by Western countries, which were lifted earlier this year. That means remaining members will have to impose larger cuts on themselves to meet any collective goal.
And whether OPEC’s members can really agree among themselves is an open question. Iraq, the group’s second-largest producer, is already balking at how exactly its proposed output cut is going to be calculated. Saudi Arabia, the largest producer, will probably have to accept the biggest individual cut as part of any agreement. But will the Saudis tolerate that when their archrival, Iran, is being granted an exemption? Moreover, Russia, which had previously agreed to work with OPEC to reduce production, is now reportedly backing away from making any cuts.
As I see it, there are two scenarios for OPEC’s highly anticipated meeting next month. Either the talks break up with no firm commitment to reduce production, in which case crude oil prices slide back toward $40 per barrel; or (less likely) OPEC does commit to cutting, in which case oil prices get a very temporary spike. Temporary, because in case OPEC forgot, the U.S. shale oil industry hasn’t disappeared.
The market downturn that started two years ago has sent many U.S. operators into bankruptcy and put tremendous pressure on those that remain in business. But those companies are finding ways to cut costs and continue drilling. In fact, the number of drilling rigs in operation and pursuing oil has increased by more than a third from its low point (reached in May), according to data from Baker Hughes. Any OPEC-inspired pop in the oil price will only prompt more drilling and more production. Indeed, after tumbling last year and earlier this year, U.S. output has basically stopped falling. An OPEC-engineered price spike would be a godsend for every American oilman from Houston to North Dakota.
So, to believe the current talk of an OPEC cutback, you have to believe that oil ministers from Saudi Arabia, Iraq, Kuwait and other Middle Eastern countries that have been pumping crude as fast as they can are now ready to surrender some of their share of the global oil market to energy firms in Texas. That’s highly doubtful.