When will the oil market crumble?
In the past couple weeks OPEC members, led by Venezuela and Saudi Arabia have attempted to talk back up the price of oil. Besides the obvious why are they doing this?
The last time OPEC made such an active roile in trying to talk up prices was at the start of 2016 when oil prices fell below $30 per barrel.
“The price itself is irrational if you ask me,” Khalid al-Falih, the chairman of the Saudi state oil company Aramco and one of the Kingdom’s most influential energy figures, said at the World Economic Forum annual meeting in Davos.
“Prices are supposed to be set by the marginal barrel. The marginal barrel is certainly way higher than $30 a barrel.”
Then, in February Saudi Arabia, Qatar, Venezuela and non-OPEC Russia agreed to freeze output at January levels. Buoyed by large unplanned production cuts in OPEC and non-OPEC, the threat of cuts at their June meeting and weakness in the US dollar, oil prices then rebounded to over $50 per barrel by the summer.
And now after oil prices briefly tipped below $40 per barrel Saudi Arabia’s energy minister, Khalid al-Falih, said members of the OPEC cartel and other major producers would “discuss the market situation, including any action that may be required to stabilize prices.”
Despite protestations that cuts to production are on the table, the reality is that OPEC are very unlikely to actually do that which is why they are being so robust in their efforts to talk up the market.
It all comes down to debt.
When oil prices were high oil producers borrowed heavily against the value of that oil. This year OPEC’s net oil export income this year is forecast by the Energy Information Administration to hit its lowest level since 2003 in real terms.
As Bloomberg’s Gadfly notes “suddenly finding yourself saddled with huge debts and savage cuts to your income understandably leaves you feeling depressed. And when oil producers get depressed, they don’t retreat — they pump more oil.”
As Jaime Caruana of the Bank for International Settlements laid out in a speech earlier this year:
Highly leveraged [oil] producers may attempt to maintain, or even increase, output levels even as the oil price falls in order to remain liquid and to meet interest payments and tighter credit conditions. Second, firms with high debt levels face stronger imperatives to hedge their exposure to highly volatile revenues by selling futures or buying put options in derivatives markets, so as to avoid corporate distress or insolvency if the oil price falls further. If financial constraints contribute to keeping production levels high and result in increased hedging of future production, the addition to oil sales would magnify price declines.
There is another weak link in the debt burden, one that if prices fell below a certain level could provoke much sharper falls.
At the start of the year, Sovereign Wealth Funds (SWF) belonging to oil-exporting countries dumped billions in risk assets to help prop up their current account and budget deficits, that due to the sharp drop in the oil price had been been made worse.
However, as JP Morgan calculate if oil prices fell below $40 per barrel on a sustained basis this could provoke SWF into more selling. Indeed, the faster oil prices drop the faster the value of oil and other risk assets will recouple, increasing the risk of a return to the situation at the start of 2016 where pretty much all assets – oil and other commodities see sharp falls.
How long though before the market realises that OPEC can only talk up the market for so long? Oil producers can only cry wolf for so long.
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