On Friday (27th Oct) the Brent Crude oil price reached $60.53 for the first time in over two years. All of this in a week that saw US inventories of the commodity fall for the 5th consecutive week and reports of plans for an extension of the production curbs by OPEC and Russia that have been in place since the beginning of 2017. This should, in theory, have investors jumping for joy at the prospect of a rebalancing of the oil industry at last. And yet, rightly so, they remain cautious.
Falling inventory levels in the US and rising Brent Crude Prices are, indeed, a positive indicator for the oil industry. But the key question remains one of sustainability – is this a trend that is going to last and is the ‘oil glut’ finally over?
There are two key aspects to this discussion.
1. Have the OPEC/Russia production cuts worked?
At a superficial level, it would appear so – US inventories are falling, oil prices have risen over 109% since their crash to $28.94 in January 2016, and OPEC production levels are falling by approximately 517,000 barrels per day (net). Moreover, growth in the world economy has further improved the supply vs. demand balance that has been so unstable in recent years.
However, OPEC and Russia’s efforts to curb production have not existed in isolation. While OPEC and Russia have been cutting oil production levels, the US shale industry has brought more rigs on tap and is returning to 2014 highs. The production in the US Permian rigs in particular has increased nearly 3x per rig (currently at 572 b/d) and this is not inclusive of the 2,330 ‘drilled but incomplete’ wells still to be brought onto tap. As such, while OPEC and Russia have been working to clear the global oil glut, US shale producers have been benefitting from the oil price rises as well as increasing their share of global production - diluting the effect of the OPEC/Russia cuts.
Therefore, it appears that though for the industry as a whole the OPEC/Russia cuts have helped to reduce oil inventory levels, OPEC members – particularly Saudi Arabia – may have taken on a significant sacrifice that the rest of the industry has benefitted from. This being said, they are still not actually providing a long-term solution to the problem of over-supply – self-imposed restrictions cannot and will not last forever.
2. What does a post-cuts world look like?
While OPEC and Russia have largely adhered to the agreed cuts, it is clear that they are not a long-term solution and the words ‘exit strategies’ are increasingly being uttered by journalists and investors alike. What investors and journalists are actually probing at is whether there will be a return to over-production as soon as the restrictions are lifted. However, recent indications suggest Russia and OPEC intend to focus on a continuation of the production cuts into the beginning of 2018 – and their meeting on November 30th will quite likely centre on this – any possible exit strategy that the group come up with is already highly anticipated by investors.
Should OPEC/Russia fail to gradually remove the production curbs its members have agreed to, many fear there will be shocks to the market and a downward spiral towards the return of an oil glut that would come with the freedom of all oil producers to produce as much oil as they wish.
To ensure that the impact the cuts have had sustain some kind of longevity OPEC will need to carefully find the balance between not re-flooding the market and remaining competitive as individual producers. Deciding the correct way in which to approach this will also be a point of contention for the OPEC leaders. As many have asked in recent months: at what point are production curbs antithetical to the capitalist and profit-driven basis of the oil industry itself?
There is also, however, another aspect to the topic that is worthy of noting – the impact that all of this has had on Saudi Arabia. As the largest producer of oil in the OPEC nations, Saudi Arabia has bore the greatest burden in the production cuts – its 519,000 b/d reductions are practically equal to the net reduction of 517,000 b/d for all OPEC nations combined. This has contributed to further slowing of the Saudi Arabian economy: which was already suffering under the low oil prices of recent years. As an economy that is still predominantly dependent on oil, the combination of low oil prices and their self-imposed production cuts has hurt.
What is key to remember is that though the nation’s Strategy 2030 – which it argues is a solution to its economic woes - aims to rid Saudi Arabia of its dependence on oil and diversify its economy, in order to promote growth in other sectors they need strong income from oil to fund it. One of the greatest injections of funding into the Strategy 2030 will come from their planned IPO of 5% of Saudi Aramco, the nation’s state owned oil-company, from which Saudi leaders hope to bank $2tn. However, to achieve this $2tn figure requires both Aramco’s output and oil prices to be at attractive levels for investors. As such, the potential of the 2030 Strategy and Saudi Arabia’s independence from oil is, ironically, dependent on the very commodity from which it is trying to wean itself off of.
Therefore, finding the balance in production levels for the OPEC nations post-production curbs is crucial beyond simply preventing shocks to the market and re-igniting an oil glut – it determines the plausibility of Saudi Arabia’s future economic plans.
While many will be celebrating the year-high Brent Crude prices at market close on Friday, these prices are celebrated amidst a pivotal time for the industry. Any exit strategy that is pursued will undoubtedly face criticism from all corners, and rightly so. It will be a key determinant in not only Saudi Arabia’s plans for independence from oil but also whether the production cuts were of any use in the first place for long term oil prices.