Saudi Arabia and OPEC Manipulate Oil Prices
About eighteen months ago the international price of WTI Crude Oil, at the
close of June 2014, was $105.93 per
barrel. Flash-forward to today; the price of WTI Crude Oil was just holding
above $38.00 per barrel, a drastic fall of more than 65% since June 2014. I
will point out several reasons behind this sharp, sudden, and what now seems
to be prolonged slump.
The Big Push
Despite a combination of factors triggering the fall in prices, the biggest
push came from the U.S. Shale producers. From 2010 to 2014, oil production
in the U.S. increased from 5,482,000 bpd to 8,663,000 (a 58% increase), making
the U.S. the third largest
oil-producing country in the world.
The next big push came from Iraq whose production increased from 2,358,000
bpd in 2010 to 3,111,000 bpd in 2014 (a 32% increase), mostly resulting from
the revival of its post-war oil industry.
The country-wide financial crunch, and the need for the government to increasingly
export more to pay foreign companies for their production contracts and continue
the fight against militants in the country took production levels to the full
of its current capacity.
In addition; global demand remained flat, growing at just 1.1% and
even declining for some regions during 2014. Demand for oil in the U.S. grew
just 0.6% against
production growth of 16% during
2014.
Europe registered extremely slow growth in demand, and Asia was plagued by
a slowdown in China which registered the lowest growth in its demand for oil
in the last five years. Consequently, a global surplus was created courtesy
of excess supply and lack of demand, with the U.S. and Iraq contributing to
it the most.
The Response
In response to the falling prices, OPEC members met in the November of 2014,
in Vienna, to discuss the strategy forward. Advocated by Saudi Arabia, the
most influential member of the cartel, along with support from other GCC countries
in the OPEC, the cartel reluctantly agreed to maintain its current production
levels.
This sent WTI Crude Oil and Brent Oil prices below $70,
much to the annoyance of Russia (non-OPEC), Nigeria and Venezuela, who desperately
needed oil close to $90 to
meet their then economic goals.
For Saudi Arabia, the strategy was to leverage their low-cost of production
advantage in the market and send prices falling beyond such levels so that
high-cost competitors (U.S. Shale producers are the highest cost producers
in the market) are driven out and the market defines a higher equilibrium price
from the resulting correction. The GCC region, with a combined $2.5 trillion
in exchange reserves, braced itself for lower prices, even to the levels of $20 per
barrel.
The Knockout Punch
By the end of September 2014, according to data from Baker Hughes, U.S. Shale
rigs registered their highest number in as many years at 1,931. However, they
also registered their very first decline to 1,917 at the end of November 2014,
following OPEC's first meeting after price falls and its decision to maintain
production levels. By June 2015, in time for the next OPEC meeting, U.S. Shale
rigs had already declined to just 875 by the end of May; a 54% decline.
The Saudi Arabia strategy was spot on; a classic real-life example of predatory
price tactics being used by a market leader, showing its dominant power in
the form of deep foreign-exchange pockets and the low costs of production.
Furthermore, on the week ending on the date of the most recent OPEC meeting
held on December 4th, 2015, the U.S. rig count was down even more to only 737;
a 62% decline. Despite increased pressure from the likes of Venezuela, the
GCC lobby was able to ensure that production levels were maintained for the
foreseeable future.
Now What?
Moving forward; the U.S. production will decline by 600,000 bpd,
according to a forecast by the International Energy Agency. Furthermore, news
from Iraq is that its production will also decline in 2016 as the battle with
militants gets more expensive and foreign companies like British Petroleum
have already cut operational budgets for next year, hinting production slowdowns.
A few companies in the Kurdish region have even shut down all production, owing
to outstanding dues on their contracts with the government.
Hence, for the coming year, global oil supply is very much likely to be curtailed.
However, Iran's recent disclosure of ambitions to double its output once sanctions
are lifted next year, and call for $30
billion in investment in its oil and gas industry, is very much likely
to spoil any case for a significant price rebound.
The same also led Saudi Arabia and its GCC partners to turn down any requests
from other less-economically strong members of OPEC to cut production, in their
December 2015, meeting. Under the current scenarios members like Venezuela,
Algeria and Nigeria, given their dependence on oil revenues to run their economies,
cannot afford to cut their own production but, as members of the cartel, can
plea to cut its production share to make room for price improvements, which
they can benefit from i.e. forego its market share.
It's Not Over Until I've Won
With news coming from Iran, and the successful delivery of a knockout punch
to a six-year shale boom in the U.S., Saudi Arabia feared it would lose share
to Iran if it cut its own production. Oil prices will be influenced increasingly
by the political scuffles between Saudi Arabia and its allies and Iran. The
deadlock and increased uncertainty over Saudi Arabia and Iran's ties have sent
prices plunging further. The Global Hedge Fund industry is increasing its short
position for the short-term, which stood at 154 million
barrels on November 17th, 2015, when prices hit $40 per barrel; all of this
indicating a prolonged bear market for oil.
One important factor that needs to be discussed is the $1+ trillions of junk
bonds holding up the shale and other marginal producers. As you know, that
has been teetering and looked like a crash not long ago. The pressure is still
there. As the shale becomes more impaired, the probability of a high-yield
market crash looks very high. If that market crashes, what happens to oil?
Wouldn't there be feedback effects between the oil and the crashing junk market,
with a final sudden shutdown of marginal production? Could this be the catalyst
for a quick reversal of oil price?
The strategic interests, primarily of the U.S. and Saudi Arabia; the Saudis
have strategically decided to go all in to maintain their market share by maximizing
oil production, even though the effect on prices is to drive them down even
further. In the near term, they have substantial reserves to cover any budget
shortfalls due to low prices. More importantly, in the intermediate term, they
want to force marginal producers out of business and damage Iran's hopes of
reaping a windfall due to the lifting of sanctions. This is something they
have in common with the strategic interests of the U.S. which also include
damaging the capabilities of Russia and ISIS. It's certainly complicated sorting
out the projected knock-on effects, but no doubt they are there and very important.
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Moreover, despite a more than 50% decline
in its oil revenues, the International Monetary Fund has maintained Saudi Arabia's
economy to grow at 3.5% for
2015, buoyed by increasing government spending and oil production. According
to data by Deutsche Bank and IMF; in order to balance its fiscal books, Saudi
Arabia needs an oil price of $105.
But the petroleum sector only accounts for 45% of
its GDP, and as of June 2015, according to the Saudi Arabian Monetary Agency,
the country had combined foreign reserves of $650 billion. The only challenge
for Saudi Arabia is to introduce slight taxes to balance its fiscal books.
As for the balance of payments deficit; the country has asserted its will to
depend on its reserves for the foreseeable future.
Conclusion
The above are some of the advantages which only Saudi Arabia and a couple
of other GCC members in the OPEC enjoy, which will help them sustain their
strategy even beyond 2016 if required. But I believe it won't take that long.
International pressure from other OPEC members, and even the global oil corporations'
lobby will push leaders on both sides to negotiate a deal to streamline prices.
With the U.S. players more or less out by the end of 2016, the OPEC will be
in more control of price fluctuations and, therefore, in light of any deal
between Iran and Saudi Arabia (both OPEC members) and even Russia (non-OPEC),
will alter global supply for prices to rebound, thus controlling prices again.
What we see now in oil price manipulation is just the mid-way point. Lots
of opportunity in oil and oil related companies will slowly start to present
themselves over the next year which I will share my trades and long term investment
pays with subscribers of my newsletter at TheGoldAndOilGuy.com