Oil Dynamics
Oil markets have been in the news in recent weeks following the unexpected production cuts by Saudi Arabia and other OPEC+ nations, totalling 1.16 million barrels per day. The price of oil has been trending lower for almost a year since it peaked at over $120 per barrel in June 2022 in the immediate aftermath of the Russian invasion of Ukraine. The news of the cuts has caused oil prices to return to the top of their recent range of around $80 for WTI Crude from a recent low of around $67.
WTI Crude Oil – Active Futures Contract
Source: Bloomberg
The announcement of the cuts caught the market by surprise and came following news that the US had publicly ruled out refilling its Strategic Petroleum Reserve (SPR) which had been drawn down last year to keep a lid on prices. Saudi Arabia, in particular, had been expecting the SPR to be refilled once the oil price had been stabilised and viewed the position of the White House as reneging on an agreement. The obvious fracturing of the relationship between once key allies, the US and Saudi Arabia, comes hot on the heels of a very public cosying up to China by Saudi Crown Prince, Mohammed Bin Salman.
Oil markets are known, in the short-term at least, to be highly price inelastic. This means that the price is highly sensitive to the balance between supply and demand. When there is a surplus, the price can collapse. During Covid, when there was a sudden demand shock and nowhere to store the surplus oil, prices went negative for a short period. Likewise, when there isn’t enough oil to go around, prices can react violently to the upside, at least until the higher prices start to change underlying user behaviour to curb demand.
In this light, OPEC+’s actions to reduce supply have had a significant impact. In the last decade, the other main source of supply has been US shale oil and, in the past, one might have expected the US shale companies to respond with increased production. However, the chart below shows growth in US shale production has been much less than the pre-covid era.
US Shale Oil Production
Source: US Energy Information Administration
The reason is twofold. Firstly, after a decade of overproduction and destruction of shareholder capital, the shale companies are much more focused on investor returns than production growth. They are prioritising dividends and buybacks over investment in new production. Secondly, turning on production in the shale sector is not as easy as it used to be. Many of the best wells have already been drilled and there is a limit to the availability of workers and equipment which restricts what can be done. This is especially important because shale has represented almost all the growth in oil production in the past decade.
It is important to note that the demand side of the equation is equally important. China’s reopening from its Covid lockdown was expected to deliver a meaningful boost to demand. However, it is still unclear how stable the demand side will be in a slowing global economy, straining under the weight of 12 months of extremely aggressive interest rate increases. What is notable is that the OPEC+ cuts came at a much higher oil price than similar moves in the past, indicating they feel confident the equilibrium price is higher than in the past. The demand side remains important but there appears now to be a floor in oil prices below which OPEC+ will not accept and crucially has the market power to enforce.