Two Reuters articles are recommended reading prior to our story here. First this one, which describes how OPEC is having a tough time curbing production. The previous swing producer, Saudi Arabia, says these cuts are only needed for six months. But there are dissenting voices; this is an important one “If OECD stocks were to continue to draw in 2017 at the same pace as that seen over July-December, then it would take us around a year to return to the five-year average in stocks,” IEA oil analyst Olivier Lejeuene said.
Oil markets are in an over supply position. It appears long term oil demand is declining or growing more slowly. And producers that recently were not selling, such as Libya and Iran are back. Nigeria and Libya are exempt from OPEC production cuts. Then there are the US-based frackers who are now the new swing producers They are not going to follow any OPEC guidance. They will grasp any opportunity to produce and sell oil.
The second article has a slightly different view. It suggests oil prices are rising because OPEC cuts seem to be working – 92% of members are complying with their cuts. Prices have risen slightly on this news.
The International Energy Agency (IEA) raised its global oil demand growth expectations for 2017 to 1.4m bpd, up 100,000 bpd from its previous estimate. Cuts in supply with an expected rise in demand should firm prices.
The US fracking industry has added 51 new rigs this year and there is talk of close to 200 new rigs by year end. Each rig can generate 5.3m barrels of oil through 2019. These 200 rigs could generate 1,060m barrels in the period. As oil prices rise, expect more than 200 new rigs to start drilling.
Next consider some challenges faced by the OPEC cartel. Members have different production costs. This chart lists the nations producing oil and the cost of producing one barrel. Among OPEC members, Nigeria, Libya, and Venezuela have the highest total cost of producing crude oil. Bear in mind that even low cost producer Saudi Arabia is in trouble at current prices: The IMF predicts that an average price under $79.70 per barrel would result in a 2016 fiscal deficit for the Saudi government.
A challenge for an oligopoly is to keep members in line. Saudi Arabia has done this by increasing production when it needed to send a message to OPEC members who were not sticking with planned production cuts. This was the ploy used to push out US frackers and it worked for a while. But can Saudi Arabia inflict such pain on Iran and win? Last year Iran said it would not participate in production cuts until its oil production levels reach pre-sanction levels.
Another challenge is the inherent instability of an oligopoly. Watch this short (11 minute) video if you don’t understand the oligopoly and cheating problem.
The fact is, most oil comes from politically unstable places. Many of these places are suffering economic turmoil. Saudi Arabia is at war, and needs cash to keep its coddled population calm and quiet. Iran desperately needs cash to do the same with its uncoddled population. The Arab Spring sent a strong message to many OPEC members. Look again at the oil producer table above. We see six nations that are economically and politically stable; six out of 20.
What are the chances OPEC members are going to cheat on their production limits? We think well over 50%. And if they don’t the frackers will stream back into the market with more than 200 new rigs. Can OPEC then cut back more? Will Saudi Arabia increase production again to drive producers back into line? We think there is a less than 50% chance of that happening, especially with the Yemen war going on. Saudi Arabia and Iran are fighting in Yemen and in the oil markets. We don’t see oil production cuts working.