Oil Prices: No Real Recovery Yet

The pundits continue to insist that a real recovery in oil prices has arrived or will be here shortly. They will provide a host of reasons why this will occur. Meetings and comments by various individuals associated with crude production, are given far more credence than is warranted by actual results. Investors are given a daily barrage of conflicting reports, that fail to accurately give a reliable direction for prices beyond a single day.

There are many brokers, investment houses, international banks and companies that have a vested interest in trying to prop up energy prices. The reason is so much of their customer portfolios are invested in this sector. There are also numerous public and private pension plans that have sizable holdings in the oil industry as well.

As the number of individuals, companies and entire nations themselves face insolvency, the desperation will only grow. An endless parade of analysts and experts arrive on numerous news programs and channels to pontificate why both crude oil and natural gas, will bet further increasing in price shortly.

Individual investors need to question who is funding these pundits who are so willing to share their unique knowledge or expertise. Some more reputable news programs will provide the disclosure of pertinent financial relationships of these guests, others choose not to do so. Often it is a matter of not wanting to put forth the effort in discovering such connections.

So one is often left with the reality of attempting to make investment decisions on the latest news reports. A finance or oil minister will release a statement on a future meeting or will volunteer an opinion on upcoming cooperation on output limits. The market then responds with a temporary spike in prices.

After a few days the price of crude begins to drift down again. The cycle has been repeated a number of times already in 2016. Increases in price of oil at the end of January, were the result of a meeting between Russia and Venezuela, followed by meetings with Iran and Saudi Arabia with Venezuela.

In the middle of February there was another surge on news that Russia and Saudi Arabia had agreed on a freeze in output. Both Qatar and Venezuela also were united in being willing to participate, if a formal understanding was later put in place.

The talks between Russia and Saudi Arabia would seem to be significant in the fact that together they are the largest exporters of crude globally. Although Russia is not a member of OPEC (Organization of the Petroleum Exporting Countries), it was the first such meeting in 15 years. Since each of them produce over 10 million barrels of oil a day, they individually have it within their power to impact global prices.

Over the last two weeks oil continues to climb higher, because Saudi Arabia reiterated a pledge to work with other major oil producers to limit the volatility in the market. International priced Brent has finally surpassed $40.00 USD (United States Dollar) and American WTI (West Texas Intermediate) is above $35.00 USD. These price levels are all time highs for 2016.

The last time Brent traded below $30.00 USD was on February 11^th It has since increased in price by more than 35%. United States crude dipped to a low of $26.05 that day which was a 13 year low. It has since surged in price some 44% in three weeks.

If one considers that just 20 months ago, the price of crude was in excess of $115.00 USD a barrel, it brings to bear that something has dramatically changed during this rather short period of time. There has been a number of significant factors leading to the present situation in the energy markets.

The existing state of affairs in lower oil prices is being driven by two major factors. Declining demand and a glut in supply. The amount of oil available for sale on a daily basis, exceeding overall need is about 1.5 million barrels. This amount is likely to increase as the nation of Iran ramps up production, now that international sanctions have been mostly lifted. The global surplus will then move closer to 1.75 million barrels.

Russia is now producing crude at record levels, not seen since the end of the Cold War, when the Soviet Union ceased to exist. As the country is in dire economic straits, it is unlikely that there will be any drop in output within the near future. The nation is being wracked by a severe recession and is burning through its rather large foreign exchange earnings. The leadership in Russia is therefore likely to pass, on reducing the sales of its most profitable export.

As of 2015, 68% of all Russian foreign exchange earnings were derived from energy sales. Oil and gas exports make up half of all government revenues. Even though prices are down 60% or more in the last 18 months, Russia will attempt to sell as much oil as it can. It is in no position to make substantial cuts in output, when there is a definite need to raise as much capital from this source as possible.

Saudi Arabia as the worlds largest exporter of crude, made a conscious effort to increase production of oil in November 2014. The country had been losing market share for a number of years. It is the only major country in OPEC, that has the ability to really change the dynamic in oil supplies.

The Saudis decided if they increased the global supply of oil, three different benefits would eventually accrue to them. The first was to reduce competition. Saudi Arabia can produce and export oil at far lower prices than any other major country. The nation can still make money on the sale of oil, even if the international price were to dip below $20.00 USD.

The United States became one of the top 3 producers of crude in the world as of 2014, at 8.7 million barrels. Growth for that year was the largest in more than 100 years. It measured the biggest volume increase since records starting being kept in 1900. On a percentage basis output increased 16.2% , the highest rate since 1940. Production had increased for 6 years in a row.

In 2015, output surged even higher maxing out at an average of 9.43 million barrels. This was the largest production level since 1972. The rate of increase was 89% since 2008. It has since  declined, as a result of lower energy prices overall. The rig count is down and output has dropped by more than 200,000 barrels a day.

Saudi Arabia had hoped to stifle the boom in oil and natural gas in the United States by expanding supply. The effort instead forced producers in North America to become more innovative in both efficiency and productivity. Bankruptcies of smaller operations did spike 379% in 2015, but these were the least competitive companies, so overall production has been mostly maintained.

At the end of 2015, the United States was still producing 9.2 million barrels a day. It was down just 2% from the year before and 4.5% from the peak rate of output achieved last April.

Saudi Arabia had two other additional goals in bringing down the international price of crude. One was to have a far lower global price than Iran could easily tolerate. As the main competitor in the Middle East, Iran has become a major threat to Saudi security in the Persian Gulf. With the end of most sanctions, Iranian production will now increase dramatically over time. A far lower price would hamper the resurgence of Iran to international energy markets

The other goal was to circumvent the rising influence of Russia in the Middle East. Saudi Arabia has watched with growing alarm, the increased role the Russians have taken in support of the dictator Assad in Syria. The projection of Russian military power through indiscriminate bombing of targets there, can well be duplicated elsewhere in the future.

History of the region has indicated that Russian intervention is usually longer term and much more intrusive. One reason is the close geographical proximity of the Middle East to the motherland. The other is the present goal of Russian President Vladimir Putin in having his country return to a major role in the area. Russia has been largely absent from the region for over a generation.

The Saudis are used to American intervention in the region. They have made many accommodations with a number of American administrations, since the kingdom agreed to sell all of their oil by use of the United States dollar.

The American military incursions of the past are limited in their objectives and usually short lived. They more often than not, coincided with Saudis interests overall. In fact, Saudi Arabia considers the United States their ultimate guarantor in a real showdown with either Iran or even possibly Russia.

The price of oil spiked over 5% at the beginning of the week. This prompted many analysts to predict that crude will soon surge much higher, as prices return to what is considered a more normal range. In short, they see a practical doubling in the international benchmark for later this year.

The problem with these optimistic assessments is that much of the recent run up in the price for crude, has been based on news events and their psychological impact on investors. Despite numerous pronouncements of various oil ministers and spokesmen of a number of organizations, nothing has really changed since the beginning of the year.

The announcement of the freeze by the United Arab Emirates which is now supposed to be in place merely codifies a level of production, that exceeds demand by more than 1 million barrels a day. Output is still ongoing at record levels.

Also it must be noted that if Iran is able, their plan is to boost production by as much as 1 million barrels a day by the end of 2016. Their output for January was at a recent record high of 4.35 million barrels. At the very least, one could expect a rise of several hundred thousand barrels in the months ahead.

The market reality of supply and demand must eventually reassert itself. Global demand for crude and liquid fuels will average about 96 million barrels per day. Total world output is well above 97 million barrels. That is a fundamental problem for those who are predicting a continuing rise in oil price this year.

Unless there is a real agreement for production cuts by major world producers, further price rises are unlikely. Of course an unexpected event, that knocks out production in a country or a number a countries through war, a terrorist attack or by other means, could change that dynamic considerably.

Kuwait for example, has already stated they would not consider any kind of freeze on output unless all major producers participate. That will be difficult to achieve in the current environment, given the animosity among some of the major players. The announcement by the Kuwaitis matters enormously, in that they alone produce 3 million barrels a day.

An additional worry for those individuals who want to limit production, is the United States. As a result of downsizing and increased efficiency in the shale oil industry, the previous price of $70.00 USD as the breakeven point in profitability, has now been reduced to around $40.00 USD. Therefore, if crude prices remain above this benchmark for any length of time, American production will start increasing once again.

The other side in the oil equation would be increased demand. This is unlikely in a global economy where many major countries are already in recession as is the case of Brazil, Japan, Russia. Other nations have narrowly averted a contraction recently which include Canada, many nations in the European Union and elsewhere.

Slowing growth in most regions of the world including China, Latin America, Southeast Asia and even the United States make a major jump in demand for oil, highly unlikely in the near future.

Therefore despite the recent surge in the price for oil, it is likely another reversal will begin soon. Market fundamentals just do not support the present price valuation. As the dismal reality of the slowing global economy becomes more evident, investors will question why prices are not dropping?

It will not be long before the charade of the OPEC plus Russia agreement to a freeze, is seen for what it is. A basic understanding to keep output well above demand. What it actually did was provide major producers of crude, a temporary windfall in extra profits.  Fundamentally, nothing has really changed. It is almost somewhat fraudulent in that the two major producers Saudi Arabia and Russia, would be hard pressed to increase production much higher anyway.

All of these facts will necessitate a drop in oil prices. Inventories are at all time record levels in many countries. There is simply no place left to store more output, unless companies and nations begin to build much larger facilities. It is a cost hard to justify in the current energy market, where the supply glut is growing and ongoing. Investors who are taking the gamble that oil prices are going to continue to move up, are about to be disappointed.