Friday, 18 December 2015

Why oil prices will remain low in 2016

This report misses a few crucial details about the global oil dynamics. Saudi Arabia’s decision to increase its oil output doesn’t make a lot of sense if you read this report in isolation. Indeed, it looks horribly “suicidal” as one of the quotes suggest.

The fact that oil is the Gulf’s only real raw materials export is partially true, the GCC states also make a lot of money from being a money house, smuggling haven and precious stones mover. But yeah, oil makes up a large share of its livelihood, so any movement in the price will affect their bottom line. That’s understandable.

More than oil price though, Saudi is concerned with market share. OPEC is dominated by the Saudi player followed by the other GCC countries, so any moves the make have massive impacts across the world. They did indeed increase their output in 2014 and have kept it high, and there’s no indication they’ll drop production any time soon either. According to some reports Riyadh is trying to find ways to increase it. Why are they doing this? It’s not simple but the answer probably lies in what happened in mid-2014.

The US was moving closer to a rapprochement with Iran and Saudi officials knew it. Despite what the headlines say, the parties involved in the talks were not just the five permanent UN security council members and Germany. Saudi has a special relationship with the US and France, and the sidelines of any international talks are where the magic happens.

In those sidelines was the Al Mukhabarat Al A'amah, the Saudi intelligence service. Their presence wasn’t secret, they weren’t “spying”, it was expected. If they weren’t present, then I’d lose all respect for them. Many more players than just the five and Iran were close to those talks as well. Saudi wanted to be there because of its long-term rivalry with Iran and the threat it felt would arrive if Iran and the US became more friendly.

The Saudis knew that this particular rollercoaster was at the top of the hill, ready to come down the other side. They figured that moment was at the midpoint of last year. You can see this in the way the P5+1 talks suddenly started to appear in the mainstream press, rather than isolated in journals or in expert communities. When this happened, I wrote that a US/Iran détente was imminent. A year later, it happened pretty much on schedule with the standard diplomatic process. The Saudis also knew this.

They knew the US and Iran were coming closer, they just didn’t know how long it would take for Iran to re-enter the international community. So they needed to send a signal to the world of their displeasure and frustration that they couldn’t manipulate Obama into keeping the Iranians at arms’ length. That signal was to put more oil on the market, faster.

If the Saudis could dominate the market for a long enough time, they could “teach” the world’s oil consumers. For this to make sense, you have to understand that oil tankers don’t mix different country’s oil together when they push it over the oceans. When a crude tanker arrives at a refinery, you can be sure the oil comes from one country. If Saudi started to dominate those shipping routes, refineries and consumers would begin to expect their oil from Saudi in the future. So refineries began to shift their accounts and logistics train to prefer Saudi oil over others, further increasing the Saudi’s market share. It was a good plan.

That way, when the Iranian oil fields eventually did come online and start churning out more oil (which they haven’t yet, precisely because the plan has worked so well), they would struggle to attract enough buyers. Not only have the Iranians not got the production capacity to rival Saudi, they also don’t possess the export infrastructure to rival Saudi. Their ports are rubbish and their pipelines aren’t good enough either. The only things that really works efficiently in Iran is its bunkering and smuggling routes, but these can’t transit nearly enough oil to compete with Saudi. So Riyadh was ahead in two very important ways.

The Saudis can’t stand the idea that Iranian crude will compete with them directly. Of course, Iran and Saudi both have enormous stores of energy, so this could go on for some time.

The other factor is the US shale “revolution”. The United States is now energy self-sufficient and overtook the Saudis as the world’s largest energy exporter in early 2014. The US is not part of OPEC, so they are not controlled by the Saudis. Saudi Arabia is an incredibly efficient producer of crude with massive state-run companies doing the work.

Those companies aren’t under much pressure to change or adapt quickly because the oil they drill is extremely accessible (it actually pours out of the ground in many places). The US shale deposits require smaller companies (mom-and-pop) to be agile enough to change their ways, go bankrupt or knuckle-down if the “revolution” is to persist. That’s a big ‘if’, but it seems to be a good mix so far. However, the Americans’ oil is very difficult to access and most plays have a high break-even point. Both of these factors make the US shale “revolution” fragile, to say the least.

Again, the Saudis know this. They aren’t dumb. Their decision to increase output was also a plan to dominate market share and deny it to the Americans. Because of the high US break-even point for most mom-and-pop shale businesses, it was simple for the Saudis to knock significant numbers of them out of the market by lifting the global crude price.

Suddenly those small companies couldn’t make any profit and hundreds or thousands of US shale drills have gone quiet over the last 12 months. Obama did have a response: he promised to provide subsidies to small drilling companies IF they could prove their operation was environmentally friendly. Many went on to meet the basic criteria for these subsidies (which is all the US govt wanted) and now their break-even point is lower, which means they can continue producing. But it’s still fragile.

The Saudi/GCC move has proven extremely influential on world markets and the oil industry. The US is still the largest producer of crude energy, and they can afford the subsidies, but it’s getting difficult. The Saudis aren’t stupid, they’ll know when the time comes where they need the money more than market share. But they also know the future is unpredictable. Their hedge is a smart one and these prices will continue to be low for the foreseeable future, because they have to be.

Given the above, I’m not sure I buy the conclusion that, because the oil prices are low, therefore the world economy is slowing down appreciably. That’s not exactly a logical conclusion. When oil prices are high, these people are the first to say this is the reason the world economy is slowing. You can’t win with people who have a motive to always read danger into the tea-leaves. And if you’re selling investment advice, it always pays to convince your customers that you know more than them…

No comments: