Oil prices have hit a very rough patch, once again, down just over 20 percent since January.
This is the second downturn of the year; prices rallied last month, after OPEC and Russia made plans to come together and contemplate their soon-to-expire agreement to limit oil output.
With great fanfare, the latest version of their deal was rolled out and hit with a thud. It ended up being notable for what it failed to deliver, rather than the 9-month extension that was forged.
There were hopes for deeper cuts, an even longer timeframe, and a production ceiling for Nigeria, Libya, and Iran, all of which have been exempted from the accord because of various factors, unique to each, that has hampered their output over the past several years.
None of those elements came to pass, however, and oil prices sold-off in the face of the Saudi and Russian oil ministers at the very moment that they were holding a post-meeting press conference together.
Saudi’s Al Falih was aware of the concomitant price plunge, and, in full panic mode, he promised that the kingdom would “cover” Nigeria and Libya, and further promised, famously, to do “whatever it takes” to balance the market.
The kingdom has a lot of wood to chop. Both Nigerian and Libyan output has come roaring back, and Libya has even hooked up with one of the largest global oil traders, Glencore, to market a portion of their supply.
The supply rebound has caused a global glut relapse, with various regional markets swamped with crude oil, ranging from the Atlantic Basin to the North Sea to Singapore.
The market is so oversupplied and worried about this condition persisting that it is ignoring, almost completely, the red hot geopolitical situation in the Middle East, which devolves from the top line rancor between Saudi Arabia and Iran.
Normally, these factors would create a large “risk premium” of a multiple of today’s prices. And make no mistake, these tensions in the region represent a type of potential energy for a formidable rally, if direct hostilities were to break out.
In the fight over Syria, Iran is getting support from Russia and China, while the Saudis are aligned with their historic Gulf allies and the United States. Qatar is getting aid from Iran in its row with Saudi Arabia and other Gulf states.
In another development, Saudi Arabia promoted Mohammed bin Salman to Crown Prince from deputy Crown Prince. You should take this to mean that this is not your father’s Saudi Arabia. Bin Salman has the kingdom being much more forward leaning, in the region, with adventurism in Yemen and verbally versus Iran.
For now, however, the oil market sees the fractured relationships as a negative for prices, worrying that the supply deal could unravel. After all, if the collective group is waging proxy wars in Syria and Yemen against each other, how can they possibly stick together to limit oil supplies?
That concern was laid bare on Wednesday. The Iranian oil minister floated the idea of deepening the production cuts under the agreement (which Iran is exempt from); the suggestion was dismissed within hours by three OPEC delegates.
The other factor underestimated by OPEC has been the rebound in U.S. production from both the Gulf of Mexico and the shale producers. We have only just begun to see the shale output hit the market from the attendant rise in the U.S. rig count. U.S. production could hit 10 million barrels per day by year-end, from 9.3 million, currently.
At this point, if there is no industry response, prices will grind lower. The OPEC, non-OPEC deal adherents need to do more, but it may be unpalatable for them to give up increasing amounts of global market share. China has actively shopped around for supply from sources, in response to the cutbacks.
It may sound like heresy, but the best tactic for Saudi Arabia may be to unleash its productive oil capacity and crash the market. They are by far the low-cost producer, and an ultra-low price environment would harm their regional rivals, although Iran knows how scrimp along very well, after years of sanctions.
While the bear case for oil prices is quite compelling, the new crown prince is an unknown quantity and tensions in the region could ignite and turn into direct confrontation between several of the Middle East’s prime actors.
The most likely way forward for prices is lower still, into at least the mid-$30 range, which is worth playing for (read: short); however, insurance against an upside price spike from an exogenous event needs to be part of the plan.