Monday, October 20, 2014

Max Pain in the Oil Market

There is a saying in the oil market that prices always move to a point of "max pain" before there is a change in direction. In other words, almost like in wrestling, a group of market participants have to tap out of the market due to economic suffering.

A little pain doesn't stall a trend; it has to be pain to the point where fundamental action by a group of suppliers or consumers takes place. For example, in 2008, when there wasn't sufficient oil supply due to the peak and decline in global conventional onshore oil production, global consumers were forced to a point of max pain at $150 per barrel to force a cut in oil consumption to match limited available supply.

The decline in conventional oil supply and the post-2009 high oil price environment funded new supply from a new high cost source - US tight oil suppliers (frackers). This group is now in the cross-hairs of market max pain in late 2014. And the process has just begun.

Oil, currently just above $80 per barrel (basis WTI crude), appears now to have OPEC's blessing to move further into the low $70s and possibly the $60s.

OPEC (effectively the Saudis) have in the past week rejected discussing a cut in supply to support prices. This is an unusual statement for a group that only a few months ago stated that $100 oil was a target they would support.

OPEC have a history of only allowing oil prices to free-fall when there has been a specific focused agenda. The agenda in late 2014 has just become very clear: to knock financially fragile US tight oil suppliers (frackers) out of the market. This will reduce oil supply and in the longer term may net much higher oil prices for OPEC.

Time Slippage
Even if discussions of an OPEC cut were to begin today, the oil market has an internal momentum that takes time to turn. Unlike interest rates which can be raised and lowered at the stroke of a pen, the oil market operates in the real physical world where there is inventory in storage, transport issues and other factors that slow down the impact of any OPEC actions.

The slippage from initial murmurs around a potential OPEC supply cut to a formal announcement and physical supply cut is typically at least 2-3 months and at least $10-15 dollars per barrel (proportionate to current price levels).

So OPEC members are saying they are OK with lower oil prices and even when they decide prices have become too low, it will take 2-3 months to stall the fall.

Balancing Budgets
A legitimate point that many are raising is: aren't all these OPEC members' government budgets dependent on higher oil prices? How can they tolerate lower oil prices?

Over a third of global oil supply is now coming from oil producing nations that have in the past few months begun borrowing and running down cash reserves to cover government budget deficits due to lower oil prices. The break-even crude oil price for a few government budgets is roughly:

Iran $135
Venezuela $120
Nigeria $120
Iraq $115
Libya $110
Russia $100
Saudi Arabia $95

Fortunately for most of these oil dependent nations, thanks to higher oil prices in recent years, government debt levels are at, or close to, record lows (see chart below). Cash reserves are also high (Saudis have $747bn, or three years of government spending, in reserves). So the capacity is there to borrow. Furthermore, interest rates are at or close to record lows. So, coupled with capacity, there is an economic incentive to borrow, if necessary.

Cheap interest, record low OPEC debt levels and high cash reserves mean that OPEC members have the financial firepower to make this low oil price market rout long and painful for high cost US tight oil suppliers that have taken market share from OPEC over the past four years.

In summary, the current low interest rate environment, low OPEC debt levels and high cash reserves are enabling and could prolong this oil price collapse. Oil prices are likely to continue lower until OPEC members see US oil producers curtail production.
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