Is an oil price recovery in sight?

OPEC may take heart that US production is starting to fall, but its days as oil's price-setter are numbered.

by Adam Gale
Last Updated: 23 Feb 2016

The world’s most famous cartel is getting desperate. The 18-month oil price war has taken a heavy toll on the OPEC nations’ finances. Earlier in January, the Saudis suggested selling off the family silver to pay for their 15% budget deficit, and now OPEC is reaching out to the Russians to coordinate a production cut.

‘Tough times requires tough choices,’ said Opec secretary-general Abdullah al-Badri at a speech in London. ‘It is crucial that all major producers sit down and come up with a solution.’ He wasn’t talking to the Americans, who funnily enough don’t let the state control oil output. All eyes naturally turned to the Russians, who have yet to RSVP to this invitation for a pow-wow.

And why would they? Vladimir Putin and the OPEC sheikhs both use their energy resources as much for political clout as for financing their budgets, but their political objectives don’t match. Besides, if both OPEC and Russia cut production, who really wins but the Americans?

Oil promptly dropped below $30, having fallen from well over $100 in mid-2014. By then, Russia and the US had re-emerged as major producers, the later led by a technological revolution known as hydraulic fracking (possibly coming to a field near you). Normally, OPEC would have responded to the growing supply glut by slashing production to shore up the price, but this time – led by Saudi Arabia – it refused.

The Saudis know the low price hurts high-cost American shale frackers more than low-cost Middle Eastern drillers. The plan was that the frackers would go out of business and OPEC would resume its place as a price-setting cartel.

Except it hasn’t worked. A combination of aggressive hedging contracts, cost-cutting and good lines of credit with the banks has helped US firms survive the storm. Production actually peaked as late as June 2015 at 9.6 million barrels a day. As of mid-January, it’s down to 9.2 million – hardly the collapse the Sheikhs had hoped for.

There are signs that this could be changing, however. According to drilling contractors Baker Hughes, there are now 637 rigs operating in North America, having fallen steadily but surely from over 1,900 in December 2014. Most of that decline took place in early 2015, but as most production comes from rigs that are at least a year old, this hasn’t hit US output significantly – yet.

Surely this year the impact will begin to be felt, but this may not bring the Saudis much relief. For a start, the decline in US production over the next year or two could easily be offset by the return of Iranian crude to the market, and a much needed resurgence in Chinese demand looks a remote prospect.

More fundamentally though, the frackers are not so easily disposed of. If the price does indeed recover later this year, those horizontal rigs will suddenly become appealing again. Some frackers may have gone out of business, but there’s plenty of finance out there to restart the rigs under new ownership.

The result will be new and uncomfortable cycle for the oil price, characterised by peaks and troughs that are exaggerated by speculators, the only ones to gain from such a system. The OPEC nations may take some consolation in the fact that the ever rising demand for oil will bring the average price of this increasingly volatile commodity to much more palatable levels – unless the world really does lose its taste for carbon. But the days when the oil cartel could successfully control its price are clearly gone. 

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