By: Marshall Gittler
With the failure of the OPEC countries to come to an agreement over the weekend, oil is set for a long and deep decline, in my view. The supply/demand factors that are supporting it are not enough, in my view, to keep it at current levels for any length of time. Moreover, supply and demand aren’t really what determines the price of oil any more; it’s expectations. And expectations are for a continued imbalance in the market. I expect oil to fall further and believe the commodity currencies, particularly CAD, are vulnerable to this decline.
The price of oil has risen some 60% since the lows in January, with most of the gains coming after reports of talks between Russia and Saudi Arabia began leaking in February. The main driver of the recovery has been expectations that OPEC would come to some agreement with the non-OPEC producers and take action to limit the supply of oil. With supply limited, it would be just a matter of waiting until demand – which is indeed recovering – caught up.
Unfortunately, this nice plan hasn’t worked. OPEC not only can’t agree with the non-OPEC producers, it can’t even agree among itself. This should be no surprise. Saudi Arabia and Iran are currently fighting each other in third countries. Neither country has any great love for the other in a conflict that goes back nearly 1,400 years.
Going back much less time, OPEC has always had problems in reducing its output to shore up prices. Eventually they had to give up their whole country quota system and just set a limit for their overall production, and have even managed to consistently exceed that in recent years too.
So why hasn’t the price of oil collapsed even more, now that the plans have failed? Two reasons, probably. One, the supply/demand balance is a bit better nowadays. US production has fallen (slightly), as has production elsewhere. For example, just as the meeting in Qatar was breaking up in disarray, oil workers in Kuwait went on strike, taking 1.7mn b/d out of the market. That alone is enough to remove the surplus production. Venezuelan exports are lower because of technical problems at an export terminal, while Nigeria, Iraq and Colombia are struggling with bombing attacks on their pipelines. In short, there are many temporary disruptions that are taking production out.
Secondly, the market probably expects US production to continue to decline. This in my view is probably the major reason oil hasn’t collapsed. A study by Bruegel, a European economic think tank, concluded that most of the fall in the oil price recently -- 74% -- is attributable to the change in market expectations about the supply/demand balance. Supply and demand itself only account for 26% of the change in price. Oil is trading like a financial investment, not a commodity. Investors expect US oil output will continue to decline as shale oil producers get knocked out, and it’s this expectation that is shoring up the market.
Missed Opportunities for OPEC
Unfortunately for OPEC, they missed their chance. April was the month when a lot of these producers rolled over their bank loans, and with prices in the $40/bbl range, that was probably enough to ensure that they keep pumping for another six months at least. Meanwhile, there are some 4,000 wells in the US that have been drilled but are still waiting to be hydraulically fractured (fracked) so that they can start pumping oil. If this “fracklog” is reduced by even just 170 wells a month, it could add 400k to 600k b/d to global supplies.
In other words, the price is no longer determined by what OPEC does; it’s determined by what happens in the US. OPEC is for now a spent force. The cartel has neither the internal unity nor the market share to impose its will on the global oil market. Instead, the US has taken over Saudi Arabia’s traditional role as the “swing producer” of oil, raising and lowering its output to keep production in line with demand. Only instead of meeting every few months in Vienna to determine the appropriate level of supply, US oil producers take their cue from the market (and their bankers) and expand or contract their output accordingly.
Meanwhile, hedge funds and other speculators remain very long of oil futures. How long will they be willing to hold those positions? I expect that as the oil price starts to crumble, they will try to close out some of those positions. But prices will have to fall much further in order to find a buyer.
At the end of the day, it’s expectations that are shoring the market up. It may take some time for those expectations to change, but I believe they will. When it happens, I expect oil prices to fall much further – and for CAD, MXN, and other commodity-linked currencies to fall with it.