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Brian Andrew, CFA

Black Gold

Geo-politics and oil prices go hand in hand. Last week’s announcement by the Saudi Arabian king and crown prince that they were tackling corruption among royal family members led to a rally in oil prices. Still, oil prices have been moving higher for some time, likely meaning that other factors are also affecting them.

Price History

After trading above $100 per barrel in 2014, West Texas Intermediate (WTI) oil prices plummeted, bottoming near $25 per barrel in early 2016. Since then, prices have more than doubled and now stand above $55. This price movement belies the factors that affect oil prices over time. They include supply, demand and geo-politics. Often these factors are inextricably intertwined.

Oil Supply

Supply issues are dominated today by two things. The first is the Organization of Petroleum Exporting Countries (OPEC). OPEC represents a cartel of countries, many of which rely largely on their petroleum exports for government revenue. This means that when prices fall, these countries’ citizens are directly impacted. OPEC has been losing global market share for many years. Because of these countries’ dependence on oil revenue, and the fact that they’ve done little to diversify their economies, a decline in prices creates many problems. Still, they might be willing to forgo revenue in the short-term to protect market share. They normally do this by agreeing to production quotas. The problem of course is that the cartel is loosely guided by the largest producers. Saudi Arabia is the largest producer, providing 10 million barrels per day (bpd). (The world uses approximately 96 million bpd according to OPEC’s October 2017 oil report.) The next closest country is Iraq, with production of 4.5 million bpd. Countries like Ecuador and Gabon produce fewer than 550,000 bpd. As a result of this disparity and the countries’ need for revenue, holding a production coalition together is always a problem, even when faced with new competition from fracking technology. These new technologies have led the U.S. to become more energy independent; it now produces more than 50% of its energy needs domestically.

The other significant factor affecting oil supply has to do with the new technologies associated with fracking and horizontal drilling. While these technologies have been around for some time, the production cost of oil using these methods has declined dramatically as the technology has improved. In the U.S., this has led to an increase in oil production from fewer than 500,000 barrels per day to more than four million in the last decade (when updating the chart below through 2017).

black_gold_us_tightoil_production

Oil Demand

Oil demand also affects prices. According to OPEC’s October, 2017, monthly report on oil markets, demand is expected to grow by 1.5 million bpd in 2017 and another 1.4 million bpd in 2018. Driving this growth is the increase in economic activity, the report notes, particularly in the Organization of Economic Coordination and Development (OECD) countries and China. OECD countries include the U.S., and much of Europe and Japan — places where, admittedly, economic growth has moved higher since 2016.

The increase in economic activity, coupled with the lower production quotas set by OPEC and production disruption in the U.S. due to hurricane Harvey and others, has led to higher oil prices. WTI prices have moved from $43 per barrel in late June to $57 today. The graph below shows the U.S. inventory of distillates, such as gasoline. The decline is evident due to the hurricanes reducing refining capacity.

black_gold_us_distillates

However, as WTI prices are approaching $60 per barrel, it is likely that we will continue to see an increase in U.S. production as companies continue adding supply due to those higher prices.

Through September, the number of oil rigs using newer horizontal drilling technologies and operating in the U.S. has increased by more than 76% from the same period last year. Between now and the end of next year, their oil production is expected to grow by another 619,000 bpd. So while higher prices are good for OPEC, they are also good for domestic producers using higher cost technologies.

Geo-Politics

Of course the politics of OPEC and OECD-producing countries play a role in prices. The announcement last week that 200 royal family members were being arrested and/or having their assets frozen as part of a corruption round-up pushed oil prices higher because that sounds like it will create unrest inside OPEC’s largest producing country. Some, however, saw this as the beginning of the implementation of a long-range plan that will attempt to wean the Saudi Arabian economy from its heavy dependence on oil revenues (today 80% of the economy is tied to those revenues).

In countries such as Venezuela and Brazil, rampant inflation and unrest also create a difficult situation. In the case of Venezuela, an OPEC member with relatively modest production, it can’t afford to reduce the revenue derived from oil production because of local political unrest.

Geo-political events will always be part of the oil price puzzle. Understanding them may assist in determining their impact on prices; however, they represent one of the more difficult aspects of price discovery in the energy markets.

It is possible that if global economic growth peaks near the current level, demand for oil will level off. Current higher prices will provide the opportunity for U.S. frackers to put more horizontal wells into production, and this additional flow could stabilize oil prices. In addition, the U.S. continues to receive benefits from the increased efficiency in energy use, which dampens the growth rate for energy use even when economic growth moves higher. For these reasons, we don’t believe that we are seeing the beginning of another more substantial leg up in oil prices. Rather, it seems possible that prices will remain range-bound not too distant from their current level.

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Views and comments expressed in this blog are those of the author and do not necessarily represent the positions of Cleary Gull or fellow Cleary Gull associates.