Oil prices have entered a bearish trend despite short-term bounces, supply cuts and improved demand estimates.
The lateral range of $50-$55 a barrel was recently broken, with the new long-term support level for Brent edging closer to $45-$47 rather than $50 a barrel. With money managers’ net length exposure to crude prices at the highest level in months, the risks for oil prices seem tilted to the downside.
There are various reasons for this trend.
The supply cut deal struck between members of the oil-producing cartel OPEC and non-members is ineffective and under question. We read everywhere that compliance is 90 percent, but Saudi Arabia is, in reality, the only member that is reducing output by a lot more than agreed according to OPEC figures (130,000 barrels per day cut above its agreed production), while Russia is at almost at a third (118,000 b/d versus the agreed 300,000 b/d).
Meanwhile Emirates, Kuwait, Venezuela, Algeria and others are between 50 percent and 60 percent compliance on the agreed cuts. Only Angola is cutting more than announced. This reliance on Saudi Arabia doing all the work is dangerous. Saudi Arabia has already announced it will increase output above 10 million barrels per day in February.
Iran keeps pumping out oil at record levels and Iraq is increasing its output to multiyear highs. Oil exports from Iran in February reached 3 million b/d, a level not seen since 1979. According to the International Energy Agency, Iraq will increase its output to 5.4 million b/d by 2022. Similarly, Iran is expected to boost production to reach 4.15 million b/d in 2022. These barrels are of high quality and abundant, as reserves have been underdeveloped for years.
Additionally, U.S. production is rising faster than expected. U.S. oil production has increased by 400,000 b/d from the lows, according to the IEA, surprising consensus that thought that shale would not recover before Brent reached $65 a barrel. Shale breakeven is now at the high $30s-low $40 a barrel level, and OPEC has underestimated the strengthening balance sheets and improvement of efficiency seen in U.S. companies. The U.S. is on track to deliver a 1 million barrels per day increase in production from December 2016 to December 2017, according to IEA estimates. This is before any tax cuts from the new administration, which would lower the breakeven price even further.
Despite cuts, inventories remain elevated. At 66 days of supply, OECD inventories are at a six-year high compared to 55 days in January 2011, and 287 million barrels above the five-year average. U.S. crude inventories are close to record highs as well, as shown in the Energy Information Administration (EIA) data.
The main element that analysts skip is that the so-called “lack of investment” is just the burst of a bubble. While many point to capex cuts as the driver of a new super-cycle, few seem to understand that the increase seen in oil and gas investments from 2004 to 2013 was created by the bubble of low interest rates and perception of ever-rising oil prices, not by demand. Capex multiplied in real terms to more than $1 trillion per annum in a decade of excess, creating a structural overcapacity.
While demand growth has been healthy year-to-date, consensus estimates seem too optimistic. International agencies get used to correlations of growth and oil demand that simply do not work and have been broken for years. Efficiency, technology and substitution continue to improve exponentially. This technology and substitution did not stop due to low oil prices, as OPEC expected. Solar, wind, electric vehicles and other alternatives continue to thrive despite lower fossil fuel prices.
Let us also remember that a stronger U.S. dollar and the Trump administration’s “America First” policy destroy the geopolitical premium attached to the oil price. The U.S. can become fully energy independent by 2019, and a monetary policy that finally normalizes rates and supports a strong dollar has an impact on the price of a barrel, which trades U.S. dollars.
The fact that oil prices remain in a bearish trend despite the largest cut in history and money managers’ net long exposure to crude at 10-month highs, shows us that the market is not only very well supplied. It remains oversupplied. Bulls maintain that the market will be balanced in six months. They said the same six months ago.
OPEC and oil producers should focus on being a competitive, flexible and reliable suppliers. Further cuts will only weaken their position.
Daniel Lacalle is a PhD, economist and fund manager, author of “Life In the Financial Markets” and (with D Parilla) “The Energy World Is Flat”. You can follow Daniel on Twitter @dlacalle_IA