The Final Step in Oil's Recovery

The Final Step in Oil’s Recovery

by | published February 9th, 2016

As the $600 million signal that hit last week shows, oil prices are ready to start climbing. There is just one last thing that needs to happen…

Today is a case in point.

This morning’s International Energy Agency (IEA) report on global oil demand projections, combined with the continuing oil supply glut, pushed oil prices below $30 a barrel.

What we have here is the classic balance of supply and demand. Here, the levels of investment and investor interest in oil and natural gas companies follow a simple logic.

When supply exceeds demand, investors lose interest and prices fall. On the other hand, when demand outgrows supply, investors go back in, raising prices.

But these days that dynamic has been fundamentally altered…

For the first time in my memory – which spans over four decades in this business – half of that equation is no longer in question…

And that leads us to the final step needed for oil prices to recover…

Supply Is No Longer a Concern

We know the supply side is covered… and then some.

There are more extractible reserves available, both conventional (stick a vertical straw down and suck it up) and unconventional (shale and tight, recovered using horizontal drilling and fracking) oil – more than anybody could have predicted five years ago.

And with thousands of American companies (most private and small) as well as entire countries dependent upon selling whatever they can extract, the supply side has remained stubbornly in surplus.

Demand continues to increase, although not at the level of supply. That’s because supply is here reflecting the needs of national budgets and the bottom lines of companies, rather than those of the market as a whole.

That means a downward pressure on price.

In the past, that would result in a cut back in production and the setting of a new pricing equilibrium. These days, that rebalancing mechanism has stopped working, as everyone expects additional supply to easily come on the market as soon as oil prices inch up.

One requirement to break oil out of this pattern has already happened. As I wrote last week, a $600 million signal that oil is ready to move up just happened.

Now, just one more thing has to take place for oil to start rising…

OPEC is Hurting for a Deal on Production

In short, there has to be an agreement by the primary global producers to cut production.

And there is plenty of incentive for this deal to happen.

Every OPEC member is now into significant deficit financing and budget cuts due to the low crude price. With the notable exception of Saudi Arabia, Kuwait, and the United Arab Emirates, every other member of the cartel has lobbied for production cuts.

Even so, OPEC members are increasing sales as much as they can, in a desperate attempt to shore up their budgets. And OPEC, for the first time in years, has effectively suspended members’ monthly production quotas.

Of course, this only guarantees further over-supply, and so even more downward pressure on oil prices. Saudi Arabia, which can weather current oil prices for some time, is nevertheless intent on pushing out the higher-cost producers of the world. Only an internationally coordinated production cut would sway the Saudi’s to change their mind.

Meanwhile, the world’s other big, centralized oil exporter needs an oil deal… fast.

Russia Cannot Last Much Longer

Russia is once again experiencing a run on the value of the ruble, as well as rapidly growing inflation.

The ruble exchange rate is now pushing up to 80 to the dollar, putting another round of pressure on central bank hard currency reserves…

And on its budget.

You see, Moscow must trade oil in dollars, as do virtually all other international exporters and importers. That makes the price of oil (in dollars) crucial to the national budget.

But this budget was put together with the expectation of a $70-$80 per barrel Brent price (the international benchmark crude oil price set daily in London), and was later painfully and ineffectively revised closer to $50 per barrel.

But even that is not enough, with Brent currently hovering around $30 per barrel.

So Russia, just like OPEC, is hurting badly from lower prices, and would benefit from any deal to boost prices.

But just like Saudi Arabia, they’re not going to cut production alone. That would do nothing but decrease their own revenue.

Any attempt to agree to rebalance supply to current demand levels, therefore, must be led by an international accord to cut production together.

This deal must be led by OPEC and Russia – oil exporters with control over production and sales under centralized government control.

When that happens, oil will start climbing.

But even before it does, a variety of new energy investments are opening up. For those, check your inbox on Thursday.

[Editor’s Note: Click here to see Kent’s in-depth take on the worsening situation in Russia, and how you can profit from it.]

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  1. EdInvests
    February 9th, 2016 at 16:02 | #1

    If the supply is really only a million bbls/day over demand, then it seems that the fabric of the commodities market could be torn with a simple action by Russia. They control a significant portion of the supply. If they announced that they are now setting a price for their oil, say $70, the world would have no choice but to buy from them up to the demand level. They might take a hit on less sold, but would more than make up for it in getting a good price for what did sell. The gamblers that determine the price of oil would panic and oil would suddenly be in a bull market and rise quickly. The real facts seem to be that the oil prices today do not reflect the true value of oil and is seems odd to me that producers like them seem to feel helpless.

  2. Charles Torrey
    February 9th, 2016 at 16:37 | #2

    It seems as if oil eludes market forces and is captive to political forces. There just seems to be so much production capacity that OPEC can totally control the price by driving it lower with excess production or higher with a reduction in production. when will the market balance without political intervention.

  3. Old Jim
    February 9th, 2016 at 18:00 | #3

    About 10 years ago, when fuel prices were about what they are now, I recall an OPEC minister saying that they were perfectly content with crude trading in the $28-32 range. I guess the speculators that were able to leverage prices up to stupid levels shortly thereafter, created an extraordinary amount of greed, short-sightedness and ignorance in the minds of those budget and finance officials whose countries are reliant so heavily on oil revenue. They never thought it would ever come back down to reality. I have personally felt all along that oil prices played a large part in the “great recession”, that too many people who were so extended/overextended on personal finances, could not take the additional $200-$500 per month in fuel costs, which led to massive cutbacks in discretionary spending, which rippled through the economy like dominoes. Less $$ spent at restaurants, movies, hardware and appliance stores, new cars, Starbucks… Which caused massive cutbacks in employment, workhours, etc – which reverberated on down the line. I said in 2008, $4 gas would be the straw that broke the camels back. It concentrated such a huge chunk of our economy into the pockets of a few. It has now gone too far the other way, and prices of virtually everything should be dropping, due to reduced transport costs, but they won’t. Corporate greed is soaking up the gravy. I do think $2 gas is sustainable for our nations economy, and I feel like our country can thrive with pricing at that level. Just my $.02 and sorry to the OPEC cartel, and the Russians, and all other greedy empires that cannot live within their means on $35-40 oil prices. But I really do hope it stabilizes in that neighborhood. Otherwise we will grind the nation to a halt once again, if it does soar back to insane (obscene) prices. Enough with the greed, I am okay making a reasonable profit.

  4. xbullet1
    February 9th, 2016 at 18:09 | #4

    If Russia set their price at $70, they would sell none. Who would pay $70 when everyone else is selling it at $30? Off course, their production would essential be off the market until the price reached $70 which could still be a long time, given that Iran will bring their supply to the market soon and U.S. production would likely increase before $70 is reached. In this scenario, Russia goes bankrupt.

  5. Dean
    February 10th, 2016 at 12:41 | #5

    “Old Jim” from one old guy to another, we see eye to eye, could not agree more, and have felt the same for as long. Consumer demand normally dictates production levels. Over producing to maintain market share is ridiculous. Not only factoring in a higher cost associated with storage, transport and labor being paid when the consumer market is not there to support the costs, oil producers are compounding this insanity by paying forward out of profits uneccessarily, and driving up costs. Greed for market share by producing when the market is not their to support the production levels in this case has caused employment loss for high income positions. When folks are making money they spend it, they pay taxes on it. So consumer employment as we know drives the economy. By producing to current unsupported levels the oil companies are literally biting the hand feeding them.

  6. Jack Saunders
    February 17th, 2016 at 18:26 | #6

    US and OPEC have had a cozy price fixing relationship ever since I can remember. Now that every country on the planet has discovered their own O&G reservoirs, the glut will get worse if they can afford to produce it. But they can’t at $30/barrel. US oil companies can survive at $30/barrel, but CEO’s will not receive $10 million bonuses. We’re going to see much more diversified and streamlined O&G companies as a result. Saudi Arabia has every right to protect their market share and keep prices down as they diversify their entire economy. Russia will also have to diversify away from oil as their only revenue source. Besides, the real money is in refined petroleum products.

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