Something interesting happened on June 6 in the world of crude oil. OPEC+ (OPEC along with non-OPEC members such as Russia and a few others) decided to extend their historic production cut of 9.7 million barrels per day for an additional month until the end of July 2020.
So? Such announcements are almost non-events, one might say. Well, what is interesting is the almost unanimous intent on ‘effective compliance’ of the production cuts by all member nations.
Same-same but different
Until now, whenever the OPEC announced production cuts, bulk of the heavy lifting was done by Saudi Arabia. The other member states did not really follow through on it with actual 100% production cuts.
This time though, the member nations that fail to cut output as per their agreed share, must enact additional cuts in July, August and September in order to make up for non-compliance in May and June. Basically, sell less oil now when the prices are low, otherwise you will have to sell even lesser tomorrow when the prices are higher.
Such is the dire economic condition of almost all OPEC+ members today that, possibly for the very first time, they all appear to want to fully commit to their production cuts in letter and in spirit.
Smaller member nations are already making their intentions of effective compliance clear. Take Nigeria, for example:
“… Nigeria reconfirms our commitment under the existing agreement; Subscribes to the concept of compensation by countries who are unable to attain full conformity (100%) in May and June to accommodate it in July, August and September.” – Timipre Sylva, Minister of State for Petroleum Resources, Nigeria
Such absolute compliance will be rare indeed. If implemented in letter and spirit, it can have far reaching impact on the effectiveness of subsequent production cuts too. Saudi Arabia echoes this sentiment.
“Effective compliance is vital if we are to secure the hard won stability in the global oil market and restore confidence in the unity and effectiveness of the entire group”- Prince Abdulaziz bin Salman, Energy Minister, Saudi Arabia
Why are they doing this now? Lets try to understand this.
In the immediate aftermath of the Covid-19 pandemic, global demand for oil plunged by 30 million barrels per day. Some of this lost demand has recovered since then.
However, both the OPEC as well as the U.S. Energy Information Administration (EIA) still expect global oil demand to contract, on average, by around 8 to 9 million barrels per day in 2020 to around 92 million barrels per day (from around 100 million barrels per day in 2019).
When OPEC+ announced production cuts the shale oil producers in the US and Canada initially scoffed and hesitated to cut their production. They expected to gain more market share, like they had been steadily doing, by maintaining their output.
Alas, this time it was not to be. The rapid fall in the price of oil forced the hand of the US and Canadian oil producers and they had no choice but to stop some of their non-viable oil rigs.
As a result, between the OPEC+ and the shale oil producers, approximately 20 million barrels per day of oil supply evaporated.
It is important to note that while most of the demand contraction (market driven factors) will be done with by the end of June quarter of this year, the supply contraction (read: calibrated production cuts) will continue right until April 2022.
So, as things stand today, when we look one year forward, more planes are going to be in the air, more cars are going to be driven and as more economies emerge from lockdown, more oil will be consumed going forward. Demand is going to go up, supply is going to come down. Great story so far!
Say hello to the anti-hero of our story: Shale oil
Before US shale oil production boomed, the OPEC was able to pretty much control the direction of oil prices by calibrating the supply.
How quickly things change!
Since 2014, the OPEC has repeatedly tried to launch price wars to drive shale producers out of the market. On more than one occasion, it looked like it worked. However, pushed against the wall and staring at bankruptcy, the shale producers proved their tenacity and resilience by making technological advancements thus driving down their costs down by almost $20 per barrel. Today, majority of the US oil producers have costs between $26 per barrel and $35 per barrel.
Thanks to their substantially reduced cost of extraction the shale oil producers managed to survive, albeit by the skin of their teeth.
Not only that, they also continued pumping more oil thereby stealing market share away from the OPEC. As a result, the US became the largest exporter of oil, followed by Russia and then followed by Saudi Arabia.
No wonder the US shale production has been such a big irritant for the OPEC.
Unfortunately, just covering output costs leaves the shale oil producers without cash for shareholder dividends and corporate overheads. Most shale producers had budgeted for oil between $55 per barrel and $65 per barrel in 2020, at the start of the year.
As long as the price of oil remains below $65 per barrel, investing in new capex is unlikely.
Survival of the fittest, no more
Below is our version of the top two priorities, in that particular order, from the OPEC’s perspective before the Covid-19 pandemic hit the world (intended for satire only):
- Drive shale oil producers out of the market by flooding the market with A LOT of oil, drive prices down, hold them there, mourn the passing of Late Mr Shale Oil and regain market share
- Get higher oil prices to balance their respective governments’ budgets and support their oil dependent economies
Fast forward three months and the priorities have reversed.
In a nutshell.. or shall we say, in a barrel?
Armed with this knowledge, we can now define a broad range for crude oil prices, as things stand today. On the lower side, the prices should hold above $25 per barrel (threshold of maximum pain for the OPEC+). At the same time, they are likely to lose steam above $65 per barrel (price above which US shale producers start thriving).
Outside this range, if the price runs up too high too fast:
- The shale producers will get a new lease of life
- OPEC+ will it find more difficult to implement ‘effective compliance’ of production cuts
- More supply will flood the market
- This will push prices back lower
Alternatively, if the price goes down too fast:
- Nearly 40% of shale producers get cleaned out
- OPEC+ members effectively comply to their production cuts thereby reducing supply
- This will push prices higher
No other commodity is as impacted by sentiment as crude oil. In the extreme near term, it is sentiment that moves the oil prices and sentiment can push the price beyond our range. Nimble traders can capitalize on such extreme short term moves. (We, at Raisin Capital, wear that hat too). For everyone else, the $25-$65 per barrel should be the sweet spot for crude oil prices for the foreseeable future.
Finally, before we conclude, lets take a look at what the technical charts tell us about crude oil’s trajectory and where it is likely to head next:
| Near Term Trend | Near Term Level to watch | Medium Term Trend | Medium Term Level to watch | Long Term Trend | Long Term Level to watch | |
| WTI Crude | UP | $31 | UP | $20 | DOWN | $65 |
| Brent Crude | UP | $34.5 | UP | $25 | DOWN | $70 |
The Last Word: As things stand today, while crude oil may not be a 100 metre sprinter like Usain Bolt, it certainly is a marathon runner. We expect higher crude oil prices over the next year.
P.S.: Shale oil still remains the joker in the pack.
The risks to our hypothesis:
- Any demand shocks (second wave and the subsequent lockdowns)
- Non-compliance to production cuts as announced
- Most US shale producers surviving and riding out the next 6 month period