Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

When you've reached the point of putting your faith in Russia to bail you out, you've almost capitulated. Almost.

The oil market is at that penultimate point. The optimism that took hold last week on comments from Russia's energy minister that he might be open to coordinating supply cuts with OPEC has largely fizzled. Brent crude, having closed last Monday at a dreadful $30.50 a barrel, ended the week at a merely abysmal $34.74 (and already this week it's headed back down from there). The fact that this generated so much excitement tells you how low expectations have sunk.

Scraping
The net long position of speculators in Nymex crude oil futures and options hit a multi-year low last month
Source: Bloomberg

It isn't just that a sustained love-in between Russia and Saudi Arabia et al. looks highly unlikely. The bigger problem is that, even if it happened, it wouldn't necessarily offer the quick fix that last week's price jump suggested.

First, why it's unlikely. As so often with Russia, history gets in the way. In two of the most recent oil price crashes, in the late 1990s and in 2008, Russia increased oil output even as OPEC was cutting.

Moreover, Russia's oil companies and the government aren't really in a position to actively reduce supply. Thane Gustafson, author of "Wheel of Fortune: The Battle for Oil and Power in Russia", says that the combination of low oil prices and sanctions squeezing access to foreign capital mean "cash flow remains absolutely critical" for the Kremlin and the country's oil majors. Sacrificing barrels in the hope of juicing supply looks very risky in that environment.

Especially as the potential rewards look very uncertain.

It all comes down to global oil inventories. When Saudi Arabia put together a coalition of the willing to cut supply back in 1998, the aim was to reduce the amount of oil in storage to the point where prices would start to reflect fears of scarcity. And that is what happened (helped along by the early stages of China's investment boom).

The challenge today is bigger and complicated, critically, by shale and Iran.

The latest monthly report from the International Energy Agency shows that commercial inventories of oil in the OECD countries stood at nearly 3 billion barrels at the end of the third quarter of last year, equivalent to about 64 days of forward demand. As I wrote earlier here and here, a sustained turn in the oil price will require that "days of demand" number to start falling and probably get back below 60.

Using IEA supply and demand projections and assuming no cuts from OPEC, that ratio peaks at more than 72 days in the second quarter of this year and then begins to decline -- very slowly. Along with downside risk to demand from China's slowing industrial sector, that suggests the bottom is still not in for oil.

Now say Russia and Saudi Arabia and the Gulf state OPEC members really did cut 5 percent of their output, starting in a couple of weeks. That would take almost 1.4 million barrels a day off the market. That is a big slug and would imply, all else equal, inventories starting to fall as soon as this spring rather than in the summer. Even so, days cover would still be around 69 days in the third quarter.

In the real world, Iran would blunt the impact. As sanctions are eased, Tehran is eager to regain market share. The IEA expects Iran's output could rise toward 3.6 million barrels a day within six months, up from about 2.9 million a day in the fourth quarter of last year -- eventually offsetting half the cut outlined above.

Meanwhile, any increase in oil prices resulting from cuts would throw a lifeline to a U.S. oil industry that has held up better than virtually anyone expected in terms of output but now faces a reckoning as more cash has to be diverted to shoring up balance sheets rather than drilling more wells. As it stands, the IEA expects U.S. oil production in the third quarter of 2016 to be 660,000 barrels lower than a year earlier. Moderately higher oil prices wouldn't reverse all of that, but could mean declines are lower than expected.

Assume that Iran hits 3.6 million barrels a day by the end of the year -- slower than the IEA assumes it can -- and U.S. output stops declining in the second quarter. Under that scenario, inventories still peak in this quarter -- but they remain above 70 days worth of OECD forward demand all the way through at least the third quarter.

Glut vs. Cut
Even under a scenario of Russia, Saudi Arabia and other Gulf OPEC members cutting supply by 5 percent, working off oil inventories would take a long time
Source: International Energy Agency, Bloomberg Gadfly projections

So even leaving aside bad blood and a lack of trust between Riyadh and Moscow, would a cut even be worth it?

Phil Verleger, an energy economist, has looked at the impact of price elasticity in making this decision; that is, what is the expected increase in the oil price from supply being taken off the market. For a country such as Saudi Arabia, the price must rise high enough to offset the lower number of barrels being sold, so that overall income goes up. In this case, if a 5 percent cut sent oil prices up by 20 percent for a year, overall income would rise by 14 percent, all else equal. A seeming no-brainer.

Except that, given how little a 5 percent cut might shift the needle on inventories, average oil prices for the next year might not rise that much. A 5 percent price increase, for example, would imply lower revenue overall.

The underlying problem, as exemplified by Iran and shale, is that competition has intensified on the supply side -- which is precisely why Saudi Arabia has been maximizing production in the first place. Cutting supply would simply cede market share, and dollars, to Iran, U.S. oil firms, and any other producer that might otherwise choke off investment in new wells.  

The math shows that a 5 percent reduction just wouldn't cut it when it comes to rebalancing the market quickly. And a bigger cut, even harder to pull off, would likely provide rival producers the relief they needed to keep adding barrels of their own. The real flaw in the Russia rally is that it demonstrates just how much weaker the traditional behemoths look in today's global oil market. Unlike the old days, when they gather now to decide their next move, they must ask themselves: "Do we feel lucky?"

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net