Shale Is Just a Scapegoat for Weaker Oil Prices
When the Organization of the Petroleum Exporting Countries gathers in Vienna this week, members and non-OPEC oil producers are likely to extend the production cuts put in place in November as a way to shore up prices, which have been choppy this month. Whatever the final details look like, a mix of oil-bullish policy and jawboning are likely to be on the menu.
Oil prices have risen on trend since April 2016, but came under pressure in early May, and analysts once again pointed to U.S. shale oil production as the culprit. And while shale is a big deal, there wasn’t a major change in output that triggered the significant oil market selloff starting May 2. After all, the shale story has been playing out for some time, and oil rig counts are up around 125 percent since May 2016.
The focus on the supply side of the market to explain this recent selloff was misguided because this time, it was demand that engendered concerns: The April Chinese Manufacturing Caixin PMI, which was released late on May 1, fell to the slowest pace in seven months.
China is the critical marginal swing player for oil demand growth and consumption, and the weak Chinese manufacturing PMI -- and its implications for oil demand growth -- initiated the selloff in WTI crude oil prices that started with a close below a critical trendline that had been in place since April 2016 (diagonal line in blue). Although oil prices have risen since the early May selloff, they remain under pressure -- and traders will be taking their cues from the action in Vienna this week.
The stakes are high and traders will not want to be steamrolled by an OPEC decision designed to support oil prices. This sets up oil prices up for moves higher, especially since the OPEC gang and non-OPEC oil producers have all gotten on the same page. Their decision this week will be important because these 25 countries account for more than 55 percent of global oil production. But there is a debate over extending their oil production cuts.
The Saudis have borne the brunt so far, and some question how long they would be willing to make such a sacrifice. First, even if they lose out on near-term oil revenue from selling fewer barrels, they are not losing the oil, which they could still sell in the future -- and likely at a higher price once global oil market supply, demand and inventory dynamics have rebalanced.
Plus, those who think the kingdom won’t hold the line are overlooking one critical fact: Saudi Aramco is gearing up for an initial public offering. By reducing production to support oil prices, the Saudis are making a calculated bet that logically prioritizes balance sheet over income statement. Sacrificing some current revenue to support oil prices ahead of its IPO could boost the valuation of the entire company -- and of the shares for sale. Any corporate executive in the commodity world would willingly sacrifice short-term income losses as a way to significantly improve a company’s balance sheet ahead of an IPO. And Saudi Aramco’s worth comes from oil, which will likely be priced noticeably higher at the time of the IPO than it is now.
This week’s meeting of OPEC and non-OPEC oil producers will draw attention to a likely price-bullish supply story for oil. But next week, traders will again turn their attention to global oil demand fundamentals. At the top of the list will be the May Chinese Caixin manufacturing PMI, which will be released on the evening of May 31 in the U.S. Chinese manufacturing is a strong proxy for the pace of China’s economic expansion, Chinese oil demand growth, and global growth. As such, a decline of the Caixin PMI below 50 would represent a contraction in monthly Chinese manufacturing activity -- and it could imply slower global economic and oil demand growth. That would be bearish for crude oil prices in the near term, regardless of the OPEC policy decision this week.
Even if the May Chinese PMI falls below 50, expect a trend of monthly Chinese manufacturing expansions to accompany a likely modest acceleration of global growth over the next two years. This should support oil demand growth -- and prices -- on trend, especially if OPEC and non-OPEC oil producers rein in production at the meeting on May 25 to allow the global oil market more time to rebalance global oil supply and demand.
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