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Further fluctuations predicted for crude prices

Rig counts, demand, contango, Libya, Saudi Arabia, Iran and ever-rising supplies from North America: they all point to further fluctuations in crude prices

Oil industry executives have been saying it repeatedly: low prices are bad news, but volatility is at least as damaging.

There’s little sign of either one ending soon. An array of forces is bearing down on prices while the market keeps hunting for the level at which production growth in North America will cease or go into reverse. Sentiment among traders lurches from the bullish (usually following the release of Baker Hughes’s weekly rig count numbers, which have been showing a steep fall) to the bearish (usually following the release of the Energy Information Administration’s inventory and supply numbers, which have been showing a steep rise).

Saudi Arabia, in charge of the Opec policy to let prices fall to deal with the glut, believes that the strategy is working, say people close to the ministry. Demand is picking up, it believes, and eventually the price will take its toll on the “inefficient” producers targeted by the kingdom’s oil minister Ali Naimi.

But the evidence for this is thin. The International Energy Agency (IEA) in March revised up its global demand outlook for 2015, but by just 75,000 barrels a day (b/d). Year-on-year growth of just 1 million b/d hardly shows consumers roaring to the pump.

Demand does not equal consumption, either, especially when the contango in the market’s curve offers buyers an incentive to store crude, not burn it. China and even the US have been buying oil to build strategic stocks. But that is no pointer to any underlying price-induced recovery in consumption. Macroeconomic weakness in China will weigh on the country’s demand this year, says the IEA, as it will in the eurozone and elsewhere. In the US, the most price-reactive market in the world, consumption is rising, helped by an improving economic outlook. But as quick as the country has been to start consuming more oil again, any price recovery would have the opposite effect. Longer-term, the trends are still plain: Americans are driving fewer miles and their cars go further on a gallon of gasoline.

On the supply side, the US rig count — watched obsessively by mainstream financial media — is offering a misleading picture. For the week ending 13 March, Baker Hughes counted 1,069 onshore rigs in operation, a weekly drop of 64 and 668 fewer than in the same week last year. Canada’s rig count is now just 220, less than half the number for the same period in 2014.

But for now, these numbers are largely irrelevant. In Canada, the rigs reflect falling activity in the tight oil and conventional plays. But in the next two years the oil sands will add more than 450,000 b/d of supply from projects sanctioned before the price drop, according to Wood Mackenzie, a consultancy.

In the US, moreover, rig counts remain high despite the drops of recent months. In 2009, the last time prices were as low, the number was barely a fifth the level today. Meanwhile, the flow of oil continues apace, with fewer rigs focused on higher-yield plays. For the week ending 13 March, the Energy Information Administration said output was now 9.419m b/d, 1.2m b/d higher than a year earlier. “US supply so far shows precious little sign of slowing down,” said the IEA. “Quite to the contrary, it continues to defy expectations.” The agency revised up its fourth quarter 2014 expectations for North American production by staggering 300,000 b/d.

This can’t last indefinitely, because at some point the falling rig count will actually mean something. Opec said in its March monthly oil market report that US tight oil supply would begin to drop off in the second half of the year. That’s broadly the consensus on Wall Street, too. Citibank’s head of research Ed Morse reckons that sub-$50/b, US oil output will end the year flat, implying a tailing off of output in the coming months.

But unless demand is growing at a faster clip by then, the inventory overhang will take over as the biggest weight on prices. US stocks are now at 468m barrels, an all-time high. This partly explains WTI’s steep discount to Brent, a differential that will persist as long as US oil stocks keep pouring into Cushing and other depots. As the stored oil approaches the physical inventory capacity limit, WTI prices would have to fall to make floating storage or other alternatives profitable — either that, or the crude oil can be stored where at home, in the ground. In any event, burning off the excess of stored oil will have to precede a strong price recovery, and that will take months.

While this contango dilemma plays out in the US, geopolitics could yet rear its head again too — but, unlike a few years ago, as another bearish force for the market. The big one is Iran. Any nuclear deal will involve a lightening of the oil embargo on the country. The White House might find it difficult to push sanctions relief through Congress. But Iran knows that. Its hopes rest with the EU and other international sanctions. If these are lifted, Iranian output will rise. Although lifting production will take some time, Iran has now stored 30m barrels of oil at sea, all of which would presumably be offered to the market. To find customers for all this oil, Iran would have to discount its price to regain market share it has lost to Saudi Arabia and Iran. It’s hard to see the kingdom letting that happen without a response in kind.

Libya offers the same kind of threat to the market. The targeting first by Libyan Dawn forces and now by Islamic State militants of energy infrastructure in the oil crescent, in the centre of the country, has persuaded the market that the country’s output is too risky to count on. Production has risen since the violence-inflicted lows of January, and now stands at more than 400,000 b/d, a quarter of capacity in 2011. A sudden drop from that low base will offer little support to the market, given expectations already built into the price. On the other hand, any peace settlement could see oil output pick up quickly.

All this adds up to a weak price for the coming months, but don’t discount the possibility of a shift in policy from Opec. Saudi Arabia’s signals to the market of late have been confusing. In a recent speech, Naimi laid out the reasoning behind the kingdom’s new laissez-faire market strategy, but also implied that if Opec could secure the agreement of other producers it would cut. That’s been the case all along. In November, just before the Opec meeting in Vienna, Naimi met with the energy ministers of Russia and Mexico to discuss coordinated supply restraint to prop up prices. An agreement didn’t transpire, and the kingdom, unwilling to shoulder the burden on its own, insisted that Opec do nothing to stop the price slide. But the longer the slump persists, the more pressure will build on Opec to act. Someone will eventually have to cut. The market is still stuck in a game of chicken, with Saudi Arabia — and its history of market intervention — on one side, and on the other side scores of tight oil drillers who for now are desperate just to keep eking out more crude to keep cash flow alive and insolvency at bay.

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