October 17 1973 was a big day for OPEC: this was when it made the decision to cut oil exports to the United States and other western countries which the Arab world felt were supporting Israel in the Yom Kippur War. It precipitated a major energy crisis, the reverberations of which were still being felt in the Middle East when I moved there in 1979.
It also established the alliance of oil producing countries as a major arbiter of how much oil flowed into the global economy, creating a bloc which seemingly held a stranglehold on the price of oil. Things have changed a little since then. Firstly, with the end of the Cold War in 1989, Russian oil stocks flowed onto the international energy market. Russia is not an OPEC member, and OPEC has always been a little concerned that decisions by OPEC countries to restrict oil supplies would be greeted by Russia as an opportunity to make money.
Secondly, new sources of energy are coming online all the time. Of most importance are the shale oil reserves in North America. Economists have yet to really figure out how easy it is for energy firms in the US and Canada to turn these supplies on once prices reach a profitable point.
“While both OPEC and non-OPEC members have largely kept to the agreed production cuts (especially in the former case), American output from its seven key shale fields remains a key variable and one over which the debt and stock markets have greater influence than Riyadh, Tehran, Baghdad and Moscow,” says Russ Mould, Investment Director at AJ Bell. “The oil price’s recovery from its 2016 lows has enabled many US shale producers to refinance their debts or raise fresh capital and begin to drill again.”
OPEC has to have one eye on the shale producers now – unlike the days of yore, there is a point above which OPEC countries don’t want oil prices to go. There are now other players in the game beyond OPEC who will also start to turn on the taps. But when? Consensus seems to be around $55, and we are not far off that now.
“The focus now shifts to how US crude and shale producers respond to higher prices,” says Mihir Kapadia, CEO of Sun Global Investments. “This sector has been one of the biggest headaches for OPEC as they have been flexible in increasing output in response to higher prices. Thus, OPEC’s desire for higher prices over the medium term have been continually thwarted.”
My view is that the fundamentals are shifting under OPEC’s feet. The agreement yesterday between OPEC and 10 other crude oil producers was to cap output through to March next year. Oil had just suffered a drop of 5% ahead of the meeting, then rallied to $51.74 (the benchmark price of Brent crude).
“The decline in exports has been much less due to large stockpiles and the global supply glut has not drained in the first quarter,” says Ipek Ozkardeskaya, senior market analyst at LCG. “The inefficiency in the first six months has brought the OPEC countries and their global allies to extend the production cuts. The nine month extension has already been priced in and the oil price continues to climb on speculation of eventually longer and deeper cuts.”
Many investors had been hoping for cuts in production, perhaps pushing the price up to $55 or more. As we have mentioned on this site before, oil inventories are currently at extremely high levels. US stockpiles have been falling for seven straight weeks, but they are still high. At some point it again becomes economical to start pumping all that shale oil again. While some OPEC members may dream of the heady days of $140 oil, it seems a long way off right now.
“Assuming that US shale oil production continues to expand and global oil consumption remains fairly modest, this will only be enough to stabilise global oil prices around $55/barrel in 2017-18,” comments Cailin Birch, an analyst with the Economist Intelligence Unit. “This is far from ideal for many OPEC producers that rely heavily on oil for export receipts and fiscal revenue – who were much happier when oil prices were above $100/barrel.”
By opting not to deepen its product cuts, OPEC avoids pushing prices up quickly, which would primarily benefit US shale producers. They also avoid the prospect of a renewed price crash, which nobody in OPEC wants. Birch says oil-reliant economies are better off at $50-55 per barrel than they were at the low point of $30 seen in 2016. “This may be the best possible scenario for many countries in the near term,” he explains.
The short term fall in oil prices below $52 immediately after the OPEC meeting is a sign that the recent rally was built on “pretty sandy foundations and the hopes that OPEC would do more cutting and faster,” in the words of Neil Wilson, senior market analyst with ETX Capital.
“They seem to be hoping that global demand will pick up but it’s hard to see enough of this happening to lift crude out of its current range,” adds Wilson.
The latest meeting of OPEC saw a closer level of cooperation with Russia, but whether this lasts or not is an open question. Russia’s economy is still heavily dependent on oil, and cheap oil is bad news for the government in Moscow, but at the same time Russia is backing the Assad regime in Syria against rebels being funded by Saudi Arabia and Qatar, among others.
From the perspective of equities, Paul Mumford at Cavendish Asset Managemnt thinks the news is good for the energy sector – he sees it as a sensible step in the supply/demand equilibrium.
“Should the price rise over the longer term, as is still likely, as well as favouring US shale producers, it should prove a boost for the North Sea region, which is already enjoying a substantial uptick in activity,” he says. “In particular, it will create real opportunities for small cap companies in this space. The extended low price era forced many of these businesses to get their drilling costs way down, putting them in an excellent position to reap the rewards of a recovering oil price.”
Where can I trade oil?
Many brokers provide CFDs based on the Brent crude price. In addition, there are several ETFs that track crude oil and can be traded via a stock broker. Typical examples include iShares US Energy ETF or CMCI Oil SF, which is managed by UBS in Switzerland. There are numerous ETFs tracking shares in the oil sector, should you feel this is going to pick up. One popular play is the VanEck Vectors Oil Services ETF, while the SPDR S&P International Energy Sector ETF has seen considerable buying this month.