The Summer Oil Slump

Instead of US consumers facing $5 gasoline this summer, as some analysts had predicted, we now find prices slipping well below $4 per gallon as oil prices respond to weakening demand, a stronger dollar, and steady supply growth.  Yet as welcome as this is, it's largely the result of a mountain of bad news: Not only does financial turmoil threaten the very existence of the European Monetary Union and its currency, the Euro, but economic growth in the large emerging economies is also slowing, at least partly in response to the weakness in the developed countries that constitute their primary export markets.  The engine of global growth for the next year or two just isn't obvious.  That's the backdrop for this week's OPEC meeting in Vienna.

Before we become too enthusiastic about the prospect of a period of cheaper oil, we should first put "cheap" in context.  Even ignoring West Texas Intermediate (WTI), the doldrums of which I've discussed at length, the world's most representative current crude oil price, for UK Brent, has fallen consistently below $100 per barrel for the first time since the beginning of the Arab Spring in 2011.  Yet even if it fell another $10/bbl, to about where WTI is currently trading, it would still exceed its annual average for every year save 2008 and 2011.  So while oil might be less of a drag on the economy at $90/bbl than at $120, that's still short of the kind of drop that would be necessary for it to provide a substantial positive stimulus, particularly when much of the drop reflects buyers around the world tightening their belts. 

The US is in a somewhat better position, thanks to surging production of "tight oil" in North Dakota and onshore Texas. This has more than made up for the inevitable slide in output from the deepwater Gulf of Mexico, two years after Deepwater Horizon and the ensuing drilling moratorium. With much of the new production trapped on the wrong side of some temporary pipeline bottlenecks, parts of the country are benefiting from oil prices that are $10-15/bbl below world prices, although short-term gains are a poor reason to perpetuate those bottlenecks, rather than resolving them and allowing North American production to reach its full potential.

Then there's the issue of speculation, which some politicians blamed for the recent spike in oil prices.  To whatever extent that was true--and I remain skeptical that the impact was nearly as large as claimed--we could be about to see what happens when the dominant direction of speculation flips from "long" to "short"--bullish to bearish--as noted in today's Wall St. Journal.  Since the main effect of speculation is to increase volatility, we could see oil prices temporarily drop even further than today's weak fundamentals would suggest they should.

All of this will be on the minds of the OPEC ministers meeting in Vienna Thursday, along with the usual dynamics between OPEC's price doves and hawks.  The pressures on the latter have intensified as Iran copes with tighter sanctions on its exports and Venezuela's ailing caudillo faces a serious election challenge.  OPEC meetings are rarely as dramatic as last June's session, but the global context ensures a keenly interested audience for this one.  Given the impact of gas prices on US voters, both presidential campaigns should be watching events in Vienna as closely as any traders.  $3.00 per gallon by November isn't beyond the realm of possibility.  It would only require a sustained dip below $80/bbl.

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More Long-Term Pressure on Oil Prices

A pair of items in today's Financial Times could signal a longer run of high oil prices, even if Europe were to slip into recession and economic growth elsewhere slow. The first article (registration required) reported that Saudi Arabia has raised its target oil price to $100 per barrel, up from the $75 level that King Abdullah had previously endorsed as "fair." Meanwhile, Venezuela has announced that it would withdraw from a World Bank body for arbitrating contractual disputes, preferring them to be resolved within its own judicial system. That can't be welcome news for companies that had been considering new investments in the country's oil and gas sector. Taken together, these stories suggest both less future supply and a greater likelihood that OPEC would respond to any significant weakness in oil prices by restricting output.

With markets currently tense over the prospect that Iran might make good on its threat to close the Strait of Hormuz, the prospect of Saudi Arabia boosting output if necessary to keep prices from going much beyond $100/bbl must seem welcome, at least in the short term. But as the FT explains, the choice of that figure, rather than a lower one, reflects the fiscal realities of a broad group of Middle East producers. The Saudis, Iran, Iraq, and the UAE all require oil prices north of $80/bbl in order to balance national budgetary requirements. Considering that the cost of producing much of this oil is likely still in either the single digits or low double-digits, that is an extraordinary commentary on just how much these countries depend on oil revenues to fund the social expenditures that maintain their respective domestic status quos. So while Saudi oil minister al-Naimi may have intended his comment to convey a comforting price ceiling, it probably said as much about his government's view of where the floor should be. With UK Brent crude currently trading at roughly the same $111/bbl level that set a full-year price record last year, I'm not sure how many of us would find that reassuring.

The decision by Venezuela's dictator to exit the World Bank arbitration mechanism shouldn't have come as a surprise, with an estimated $40 billion in international claims outstanding for his past actions in nationalizing assets and arbitrarily altering contractual terms in a variety of industries. The recent ruling by the International Chamber of Commerce in favor of an ExxonMobil claim might just have been the final trigger. Yet despite the obvious expediency of such an exit, it seems grossly counterproductive in the context of a producing country that depends increasingly on foreign investment to stem a long-term decline in output. Since President Chavez punished his nation's oil industry by firing its most capable managers and engineers following a strike in 2002-3, Venezuelan oil production has fallen by at least 15%, and it only avoided a larger drop due to the contribution of the big Orinoco production and upgrading projects built by foreign firms such as ExxonMobil, Chevron, ConocoPhillips and Total--some of which are now seeking compensation for expropriation of assets and other grievances.

Requiring disputes to be resolved within a court system that has been stacked with Chavez loyalists hardly seems like the recipe for reducing political risk and reassuring companies that have already seen past investments turn sour. While companies that have too much at stake to leave will try to make the best of this, others would be well-advised to steer clear. However this turns out for the industry, the likely outcome for Venezuela is lower production in the future and even greater support for hawkish price policies within OPEC, to prop up the oil revenues upon which Chavez's redistribution policies depend.

Of course none of this guarantees high oil prices in perpetuity. After all, OPEC was unable to prevent prices collapsing to below $40/bbl in late 2008, though it did restrain output enough to get them back to around $80 within a year. However, both stories should remind us that in a world in which oil prices are set to suit producers better than consumers, our primary focus should be on actions and policies that enhance our energy security. That means substituting plentiful natural gas for oil and its products where we can, promoting conservation and efficiency, pursuing cost-effective renewables, and ensuring that we have access to as much oil from domestic and trusted international sources as possible. Rejecting the Keystone XL Pipeline, instead of committing to find a way to make it work while addressing reasonable concerns about it, would be nothing less than a gift to OPEC.

Disclosure: My portfolio includes investment in Chevron, which is mentioned above and owns projects and facilities that could be affected by these events.

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The New Oil Cycle

As of yesterday's close on the New York Mercantile Exchange, the price of crude oil has fallen 50% from its July high-water mark. The membership of OPEC must be experiencing an uncomfortable sense of déjà vu, recalling a similar drop between August 1997 and December 1998, when West Texas Intermediate (WTI) bottomed out at $10.72 per barrel, and the OPEC average price fell into single digits. The cost of production is much higher today than in the 1990s, so $10 oil is hardly in prospect, but even an extended period below $50 per barrel would cause severe pain to the oil industry and to anyone investing in alternative energy that competes with oil. However, while a return to $140 oil probably lies on the other side of a global recession, other structural changes could shorten the down-cycle, or at least put a relatively high floor under it, once the customary market overshoot has passed.

Previous oil-price cycles hold some useful insights into the likely bottom of the current cycle, but important differences are also apparent. The 1997-98 collapse was caused by a conjunction of events with strong parallels to today's situation. A wave of new oil projects collided with a sudden drop in global demand triggered by the Asian Financial Crisis. Producers faced a choice between cutting output and bearing unsustainable losses on every barrel sold, but their obvious response was complicated by two serious problems. Operators of mature oil fields employing secondary and tertiary recovery methods knew that once shut in, production might not return to previous levels, later. My former employer, Texaco, saw that happen at its century-old Kern River Field in California. Meanwhile, OPEC's members worried about a long-term loss of market share, similar to what occurred when demand for OPEC's crude fell by 44% between 1979 and 1985, requiring two decades to recover. It took an unprecedented coordination of production cuts between OPEC and Mexico, Russia and Norway--countries that might have otherwise capitalized on OPEC's unilateral cuts--to stabilize the market and nudge prices back into the $20s by mid-1999.

What's different today? Well, for starters, OPEC already has a working relationship with Russia, and the latter's output has stalled, while Norway and Mexico are both in decline. Meanwhile, OPEC has expanded to include Angola, formerly an important source of non-OPEC production growth. If OPEC cuts now, it's hard to see who would step in to steal their market share. The cartel has also enjoyed a better-than-normal degree of cohesion recently--always easier when you are producing essentially flat-out. Key producers such as Venezuela and Iran have seen first-hand the benefits of cutting a little to boost revenue a lot, and their economies depend on prices remaining near $100 per barrel.

Another important change since the late 1990s is the dramatic growth of Canadian oil sands output. The current production of 1.3 million barrels per day now constitutes a large fraction of the world's high-cost marginal supply. More than half of it comes from mining operations that could be slowed or temporarily halted with minimal impact on future output or ultimate reserve recovery. In other words, a drop in crude oil prices below the variable cost of producing synthetic crude from oil sands could be at least partly self-correcting, and fairly quickly.

Biofuels might end up in a similar position. With corn prices back down to around $4 per bushel and ethanol selling for an average of $2.22 per gallon at racks on Wednesday, the "crush spread", or gross margin for producers is around $0.80/gal, similar to where it has been for much of the year. But although ethanol had for most of the year been priced well under Gulf Coast gasoline, the sudden collapse of gas prices has inverted that relationship. With wholesale gasoline--specifically the RBOB mix designed for blending with ethanol--trading on the NYMEX at under $1.70/gal, and the ethanol blenders' credit falling from $0.51/gal to $0.45/gal on January 1, the incentive for refiners to blend more ethanol into gasoline than legally mandated is evaporating.

How quickly these factors could establish a hard floor under oil prices is anyone's guess, and I wouldn't be surprised to see WTI go well below $70/bbl before it corrects. This year's highs might have been helped along by a froth of speculation, but they were also what was required to destroy enough demand to bring a commodity with a low price-elasticity of demand back into balance with supplies that were straining at their near-term limits. That interpretation is also consistent with the dramatic fall in prices accompanying the current collapse of demand. But we can't forget that even if demand in the US and EU continue to shrink, thanks to conservation, efficiency, and alternative energy, the potential demand in Asia remains sufficient to outstrip global oil production capacity, once strong global economic growth resumes. Consumers should enjoy the relief from sub-$3.00 per gallon while it lasts, but they should not assume it will persist beyond the recession.

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