A Fake Freeze on Oil Is Good Enough
In less than a week, major oil-producing nations will meet in Qatar to discuss capping their output. Yet even if they decide to do that, the purpose of the meeting probably has little to do with balancing global supplies. Crude market fundamentals are set for many months to come; the oil producers are more interested in finding a way to manage financial markets' expectations, which have a greater effect on prices.
A freeze "at recent production levels would not accelerate the rebalancing of the oil market," Goldman Sachs analysts wrote in a report that argued the meeting would be more likely to lead to a price drop than a hike. And indeed, output levels are close to all-time records for the Organization of Petroleum Exporting Countries (above 33 million barrels a day) and near the historic high for Russia, a participant in the Doha meeting (above 11.2 million barrels a day).
Besides, some OPEC members are increasing output ahead of the meeting. Iraq, for example, hit its production record -- 4.55 million barrels a day -- in March.
U.S. producers are heading in the opposite direction. Their output is down to late 2014 levels:
Following the production decline, bloated U.S. oil inventories appear to be starting to slide, too. Though they're still near all-time records, on April 6 the U.S. government reported an almost 5 million barrel drop.
The surprising resilience of U.S. oil production is by now a market meme. Yet there is nothing miraculous about the oil industry. Producers can rely on crutches like price hedges or technological advances, but at the end of the day, it's all about how much smelly dark liquid they can extract from the ground at the right cost. U.S. frackers may have been better than anyone else at using these crutches, but now their impact is exhausted or receding. In the relatively free U.S. market, profit potential drives investment and output. And on both these fronts U.S. producers are feeling the strain.
On the other hand, Persian Gulf states and Russia need to pump oil at any price because that's how they fund their budgets, so when the price is low, they need to pump more. This is how it's going to be at least for the next few years: The traditional producers are going to win back some lost market share. The biggest problem they face has nothing to do with the physical demand-supply balance of oil. They need to keep prices as high as possible, but low enough to prevent U.S. investment and output from rising again.
The only way to do that is to manage expectations. Domenico Favoino and Georg Zachmann of the Brussels think tank Bruegel recently estimated that 73 percent of the oil price decrease in the last three years could be attributed to expectations about the physical demand-supply balance, not the balance itself. According to the researchers, the role expectations play in price setting has increased dramatically since 2008.
This is a world in which you have to convince traders that the balance is going to move this way or that, not to actually change it. That explains, at least in part, the mini-rally since the largely meaningless February agreement between two of the world's biggest producers, Russia and Saudi Arabia, as well as Qatar and Venezuela, to freeze production at January levels. The price of Brent crude is up about $10 per barrel.
Everyone, including traders, understands that such deals are iffy, that the parties won't necessarily stick to them, and that freezing production at record levels may just signify an inability to pump much more oil in the near future. Yet it's still something to trade on. If the talks in Doha on April 17 end in an agreement, even a symbolic one, that will send the market a signal to drive up the price.
That signal, however, will not be credible or lasting enough to spur an increase in U.S. oil investment. Investors and creditors are more cautious than traders. The former are scared off by high volatility; the latter are energized by it. In February, the implied volatility of the Brent crude price was the highest since 2009, at 70 percent; now it's down to about 50 percent -- still a scary level for people looking at energy industry business plans.
The Saudis and the Russians, however, don't care about the volatility all that much: They're still going to keep production as high as they can, because their populations' standards of living and their regimes' stability depend on it. So if they can send prices higher without signaling a real change of trend, that's the best they can do until they solidify their market share gains. Holding a meeting where production caps and cuts are discussed is one way of achieving that. News of the meeting can combine with shrinking U.S. output to produce temporary price rises.
It's important to produce such news regularly. It's less important to be bound by any output-limiting agreements, as OPEC has proven time and again by not sticking to its output targets.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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