The common narrative for the collapse in the price of crude oil over the past year is that the shale oil supply gut finally overwhelmed demand. I can’t disagree that ultimately, the equilibrium price of oil was much lower than the $100 WTI was trading for in the summer of 2014, but too many forget the role the Saudis played in last year’s collapse.
WTI crude oil collapsed from $100 down to $45 during the 3rd quarter of 2014. Although there were some bears that were predicting the shale oil supply gut would eventually result in a much lower oil price, the speed of the descent was startling even to the most ursine of crude oil watchers.
But many fail to recall what event started the decline. Here’s a Bloomberg article from over a year ago:
In September, despite a global oil glut developing largely because of China’s slowdown and the rapid increase in U.S. production, the Saudis boosted production half a percent, to 9.6 million barrels a day, lifting OPEC’s combined production to an 11-month high of almost 31 million barrels a day. Then, on Oct. 1, Saudi Arabia lowered prices by increasing the discount it offered its major Asian customers. The kingdom might just as easily have cut production to defend higher prices. Instead, the Saudis sent a strong signal that they were determined to protect their market share, especially in India and China, against Russian, Latin American, and African rivals. Iraq and Iran followed Saudi Arabia’s example.
The news set off a bear market in oil: Brent crude, the international benchmark, fell from $115.71 a barrel on June 19 to $82.60 a barrel on Oct. 16, the lowest price in almost four years, as investors realized that the big oil states were not going to cut production. “OPEC appears to be gearing up for a price war,” Eugen Weinberg, head of commodities research at Commerzbank, wrote on Oct. 2. The Saudi government wouldn’t comment for this story.
At the time of this article, the price of WTI was still over $80 a barrel, and the price rout was still in its infancy. From there, the Saudis really stepped up the pressure:
During a November OPEC meeting where it was hoped that Saudi Arabia and the other cartel nations would agree to cut production, Saudi Arabia instead further drove a spike in the heart of the oil bulls:
Saudi Arabia convinced its fellow OPEC members that it was not in the group’s interest to cut oil output however far prices may fall, the kingdom’s oil minister Ali al-Naimi said in an interview with the Middle East Economic Survey (MEES).
OPEC met Nov. 27 and declined to cut production despite a slide in prices, marking a shift in strategy toward defending market share rather than supporting prices.
“As a policy for OPEC, and I convinced OPEC of this, even Mr al-Badri (the OPEC secretary general) is now convinced, it is not in the interest of OPEC producers to cut their production, whatever the price is,” Naimi was quoted by MEES as saying.
“Whether it goes down to $20, $40, $50, $60, it is irrelevant,” he said.
So when market pundits say the low oil price is the result of the North American shale oil supply gut, they are correct, but the Saudis deliberately pushed the price down more quickly in an attempt to establish a new lower equilibrium price. The Saudis looked at the supply demand picture and realized prices should be lower, so they cranked supply to get the price to the new lower level.
Although their influence is waning, for the past few decades, the Saudis have been the swing oil producer. Their changes in production have an oversized effect on the price of oil.
Through their state owned oil company Saudi Aramco, the Saudis offer their oil on the world market at premium or discounts to the benchmark price. When they want to sell less of their product they raise the premium. When they want to sell more, they lower it.
If the price of oil was falling and the Saudis wanted to support the price, it would be easy for them to raise the premiums on their offerings, which would reduce supply at the lower price, and therefore help stabilize the decline. At the same time, if they wanted to accelerate the decline, they could lower the premium of their offerings which would increase supply at the lower price. The Saudis are such a massive producer, they can keep the tap on for an extended period of time and play a large role in determining the clearing price for oil.
I know it is not quite this simple. There are other actors that also play large roles. Yet I believe the Saudis purposely decided to squeeze out North American shale producers with an orchestrated decline. Now don’t misunderstand me. The price of oil was going lower regardless of the Saudis The only question is how big a role did the Saudis play in the speed of the decline, and whether the price of oil has now been pushed to a level below the long run equilibrium price.
Have a look of this chart of Brent Crude Oil versus the Saudi Aramco Light Crude Price Differential for Asia.
The yellow line is the premium/discount to the Asian benchmark while the white line is the price of Brent crude oil. Notice the almost perfect correlation.
During the second half of 2014 the Saudis lowered their price, and kept pumping. No wonder the price collapsed. They sat on the throat of the oil market and refused to get off.
But here is where it gets interesting. Have a look at the last few months. When the Saudis raised their premium, prices did not follow. In fact, during the last quarter oil prices have sunk back down.
I think the global economy experienced a fairly significant slowdown over the past six months, and crude oil’s decline was due a decrease in demand as opposed to an increase in supply. This is why Saudi Aramco’s price increase did not result in a corresponding lift in the overall price of crude oil.
In an attempt to regain market share, last week Saudi Aramco lowered their premium back down. Normally this would cause the price of oil to slump. Instead, the market shrugged it off and headed higher.
Could this be a signal that demand is finally dictating price as opposed to supply? Maybe the trader in me is reading too much into the recent crude oil price action, but there could reach a point where even with the Saudis pumping hand over fist, the price might still rally.
Have a look at the tanker rates for crude oil out of China:
Maybe China is taking advantage of the low prices and “loading up the boat?”
I was incorrectly too bullish on oil for the past few years. My thesis was that as China became more prosperous, the hockey stick demand for energy would overwhelm supply.
I underestimated both the lack of growth from the developed nations and the massive supply increase from new technological methods of drilling.
Since the oil price crash, the shale oil industry is in tatters. Although the initial knee jerk reaction to the oil price decline is for the shale companies to pump more product to help with the cash flow situation, eventually the bankers take over and force the companies out of business. It has taken a while, but supply is coming off.
As for the demand from the rest of the world, there is no doubt that it has disappointed as the recent global economic slump has unfolded.
But don’t forget changes in economic conditions show up in prices way before the media or analysts have figured it out.
The fact that oil did not sink on the bearish news, and is in fact rallying, is a sign that this decline might finally be over. Last year the Saudis started the ball rolling, and ultimately kept it going way further down the hill than even they ever imagined. The decline in the oil price has made a complete mess of the Saudi’s budget. They have just announced a budget deficit of around 22% of their GDP. Given their economic predicament, they don’t have much choice but to increase production. But even in the face of their supply increase, oil is rallying…
I am cautiously dipping my toe in on the long side of the energy square.
Thanks for reading,