It seems every second headline these days is about oil. Whether it’s the oil price, oil inventories or any comment from any official from any oil producing nation. The world is watching with extreme intensity, looking for any indication that the global oversupply of oil is starting to abate. It’s not.
The following are a brief set of notes that we have produced here at Montaka to think through the current dynamics that are playing out in the global oil markets. As you will see, there appears to be no credible short-term solution to the oversupply that persists today.
Setting the scene
- The world consumes roughly 95mb/d of crude oil. (Mb/d = million barrels per day. Oil production is typically quoted in a daily rate, rather than an annual rate which is typical for most other commodities).
- This oil is supplied by:
- OPEC – roughly one-third, of which Saudi Arabia accounts for roughly one-third; and
- Non-OPEC – roughly two-thirds, of which the US and Russia each account for about one-fifth.
- Through the course of 2015, OPEC production accelerated to a three-year high driven primarily by the acceleration in Saudi production.
- The motivation for Saudi’s production increase supposedly stemmed from the frustration of losing market share to the Americans. Over the last 10 years, US oil production has approximately doubled as a result of the fracking boom.
- This also came at a time when Russia’s oil production was hitting a post-Soviet high.
- The sharp acceleration in global supply growth had the unsurprising consequence of precipitating a collapse in the global oil price and a significant build up in oil inventories, as illustrated by the charts below.
The repercussions of low oil prices
- There are naturally winners and losers to a low oil price. On the winning side are consumers, businesses and countries that are net consumers of the commodity.
- The losers are obviously those businesses and countries that are net producers and exporters of oil. There are second-order effects too: significant investment was tied to projects that were sanctioned at $100 oil and are uneconomic at $30 oil, for example. As projects are abandoned, investment budgets are reduced and this flows through negatively to aggregate economic growth.
- What is often underappreciated are the perverse incentives that are created for oil producers (nations and companies) by excessive balance sheet leverage.
- Consider that many oil producing nations fund their public expenditures with oil revenues. When the oil price drops 70%, so too do their national oil revenues – yet their expenditures remain the same. Budget deficits build which need to be funded with public borrowings.
- So what’s the problem? Well, how easily can Russia borrow to fund their budget deficit; and at what interest rate? Or what about many of the OPEC nations? Venezuela? Iraq? Iran? Algeria? Libya? Nigeria?
- Many of these nations are already heavily indebted and the low oil price creates a significant risk of default, or even worse political unrest.
- In Venezuela, for example, crime rates are already through the roof. The nation is at very real risk of becoming a pariah state. Incumbent politicians will likely produce as much oil as possible to remain in power.
- So in a world of oil oversupply, the collectively rational response would be for producers to cut production together. Yet, the individually-rational response for a heavily-indebted producer would be to increase production as much as possible to maximize revenues at the lower prices. The worst outcome of all would be the cutting of production on the expectation that others do the same, while the others cheat and expand production!
- The same is true for heavily-indebted oil producing companies. Many are trying to produce as much oil as possible to maximize cash flow that can be used to service their debt burdens and avoid default. This too simply adds to the oil oversupply.
- Which brings us to the current state of play: low oil prices are hurting the oil-producing nations and companies of the world, yet cutting production appears too painful or risky that others would not follow.
The Saudi-Russia deal
- The following is a description of a proposed deal that looks almost farcical.
- In recent weeks, Saudi oil minister Ali Naimi and Russian oil minister Alexander Novak proposed an output freeze at January levels starting in March, if other producers agree to it.[1]
- Just as Saudi and Russia near their highest rates of production in recent history, they both agree that these are appropriate levels to “freeze” production rates at. Rather convenient, wouldn’t you say?
- There are a few problems with this proposal:
- The deal is for a “freezing” of production rates at record-high January levels for a subset of producers; not a “cut” of production in any meaningful way. As such it will do little to alleviate the pressures of low oil prices in the near term.
- Iran has supported the deal but is not subscribing to the deal itself. Iran plans to return its production to pre-sanction levels. Fair enough too. So this alone will bring another ~1.2mb/d of global supply growth this year.[2]
- Finally, not everyone believes that parties to the proposed deal will adhere to the production freeze. Remember that when Saudi persuaded Mexico, Norway and Russia to join OPEC in the last production-cut deal in 2001, Russia cheated and increased exports instead.
Could demand save them?
- Thus far we have been quiet on the demand side of the equation. Naturally, if demand growth is strong enough, then any overproduction will be consumed, the market will return to balance and prices will increase.
- Well, the oil producers just cannot seem to catch a break. From the International Energy Agency just weeks ago:
- “Global oil demand growth is forecast to ease back considerably in 2016, to 1.2mb/d, pulled down by notable slowdowns in Europe, China and the United States.”[3]
- Remember Iran’s planned production increase for this year? Also 1.2mb/d – so that rules out any improvement in the global oversupply during 2016 unless we see genuine production cuts from other producers.
This analysis suggests the most likely scenario going forward is a “lower-for-longer” oil price environment. The Montaka portfolio holds a number of positions that will benefit clients in such a scenario.
[1] (Argus Media) Saudi Arabia sees output freeze as trust-building, February 2016
[2] (Reuters) Iran offers no action in support of global oil pact, February 2016
[3] (IEA) Oil Market Report, February 2016
Andrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.
