Saudis Eat American Oil's Lunch

[ above is a photo I took in Riyadh, Saudi Arabia]

The 12 members of OPEC are Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates and Venezuela. Although there are 12 members, only one counts: Saudi Arabia.

As you will know from Oil 101, there has been an OPEC quota system in place since the 1970's , with each member country restraining supply to keep prices high. OPEC itself modeled itself on US regulators (the TRC) that had controlled global oil prices since the 1930s.

OPEC thought of itself as the Fed of oil, controlling global prices by making slight increases and decreases in physical supply. This system had always been a little shaky due to individual members cheating by producing above quotas. The quota system became less and less effective (see table below) as global conventional onshore oil production peaked and declined in 2005 and we shifted to high cost oil supplies such as tight oil fracking and oil sands.

There hasn't been a formal OPEC cut since December 2008. OPEC's individual member quota system was finally scrapped in December 2011.

In effect, OPEC is dead.

For many years now, Riyadh, and in particular one individual, Ali Al-Naimi, Saudi Arabia's now 79 year old oil minister, has set global oil prices alone (see chart below).

OPEC meets next in Vienna on November 27.

What the oil market cares about most at this meeting are the words out of the mouth of the Saudi oil minister, Ali Al-Naimi, and any Saudi Arabian physical oil market action - hence the intense interest in Saudi OSP (Official Selling Price) oil price changes yesterday. Nothing else matters in relation to OPEC.

So why meet at all? When the Saudis do cut they use the cover of OPEC to deflect any criticism that may be directed at the global oil price controller.

What do the Saudis need to do to stop prices from falling further? Until US oil supply growth begins to stall the Saudis need to cut by up to 1.5 million barrels per day. Will this cut happen? Only one man knows for sure.

Oil Price War: Crude Oil to $70

I just appeared on CNBC TV Halftime Report. Crude oil prices are headed to $70 per barrel. The last time I was on CNBC, oil (basis WTI) was $97 and I mentioned that it was going to $80. Today oil is $80 and I talked about why oil is now heading even lower.

See the TV segment here.

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.

Oil to $75: OPEC Waits for US Frackers to Blink

A main point of interest for the oil market is the floor for oil prices. As oil slides toward $75, who hurts first and most on the supply side? In other words, who has to cut production first? Here is a simplified cost curve for the marginal global oil barrel of supply today:

Another view of marginal global oil supply showing the relative scale of each source from lowest cost to highest initial production cost is as follows:

Current marginal barrels are, due to costs, US tight oil (fracked oil) and, due to government spending dependent on oil, OPEC (Saudis in particular). Ultra Deep offshore oil (in places like Brazil) and Polar oil (in places like the Russian Arctic) have not proven to be economical at any scale yet.

So in the short term, it is a battle between OPEC and US tight oil. OPEC government budgets require close to $100 oil, but interest rates are so low at the moment that Saudis and other members may choose to borrow over the short term in order to stall US supply growth and to raise the price bar for new US tight oil supply.

Still buying premium? The end of high octane gasoline

In most parts of the world, when you pull up to the gasoline pump there are two and sometimes three octane choices: regular (lower octane), midgrade, and premium (higher octane).

The price difference between regular and premium is roughly 35 cents per gallon in the US at the moment. The current price of regular in the US is $3.35 per gallon and premium is around $3.70 per gallon on average across the country.

The number of vehicles requiring premium has fallen from 21 percent to 17 percent over the past 10 years, according to Edmunds.com. But the number recommending premium, has risen from 2.5 percent to 12 percent over the same period.

So in summary, in the most recent 2014 model year, manufacturers require or recommend premium gasoline for 29 percent of US vehicles. Most consumers ignore this and buy regular gasoline. The data proves it - only 12 percent of gasoline sold in the US is premium or midgrade (see chart below).

Why is this happening? Manufacturers and vehicle purchasers are using a 'recommendation' of premium gasoline to play the MPG ratings vs horsepower game.

It goes something like this: a vehicle manufacturer wants to list the highest possible miles per gallon (MPG) rating as it is a big sticker on the window of a vehicle at a dealership. They get the high MPGs in part by putting smaller lighter engines in vehicles. However, customers also want performance. So manufacturers attach turbochargers and other premium gasoline demanding technologies to these small engines in order to keep horsepower levels up.

After the horsepower availability ego trip at the car dealer at the time of purchase, most vehicle purchasers go home, choose to go without the power, go with the cost savings, and buy regular.

See more on oil markets at Oil 101. See realtime markets at money.net

What is Driving US Oil Demand?

A few years ago it became popular to say that US oil demand had peaked and would never recover. However, the US DOT just released traffic statistics for July 2014. It shows miles driven on all US roads increased by 1.5% in July 2014 as compared with July 2013 (see chart below). If this trend holds, we will see new highs for US miles driven within a couple of years.

Although miles driven has begun to increase, this does not directly translate into an increase in US oil demand. Since the rally in oil prices in 2005, the increase in miles driven as a potential source of additional oil demand has been offset by efficiency gains occurring in the US vehicle fleet (see charts below).

Vehicle efficiency has been led by the deployment of ten technologies (listed in order in which they have become widespread): fuel injection, transmission lockup/torque converters, multi-valve engines (cylinders with more than 2 valves), variable valve timing, hybrids/regenerative braking, continuously variable transmissions, gasoline direct injection, turbocharging of small bore engines, variable displacement/deactivating cylinders, and start-stop systems.

The most recent wave of efficiency mechanisms are now, in late 2014, beginning to be overwhelmed by the increase in miles driven such that US oil demand is beginning to increase year on year. Within a few years US oil demand should make new record highs (the highest historical annual US oil consumption year was 2005).

Lower oil prices no longer help the US economy

The US currently consumes around 19 million barrels of oil per day (5% of the world's population consuming 21% of global oil supply. Global supply is roughly 91.5 million barrels per day).

A drop in prices of $1 per barrel equates to a $7 billion boost in non-oil US consumer spending when annualized. This is money which US consumers do not have to spend on oil and instead can spend on new mobile phones and other goods.

However, the US is also increasingly a larger oil producer. Since 2009 there has been an upward trend in US oil supply which had until then been declining steadily since 1973. This has been due to new high cost US tight oil (fracking) supply. With this increase in US oil production there has been a reduction in US oil imports which is expected to continue until around 2020 (see chart below). Whether this US trend can continue beyond 2020 is subject to a high degree of uncertainty at this time.

Netting the spending boost from US consumers against the revenue reduction to US oil producers, each $1 drop in oil prices currently provides only a net $2 billion annual boost to the US economy.

This is a small number given the overall scale of the US economy. For example, Apple Inc's revenue is running at $175 billion per year. So while lower oil prices in the 1990s and 2000s were almost always beneficial to the US economy, today they are neutral.

There are three caveats:

*1. Neutral until below $75: The recent increase in US oil supply is due to high prices. Marginal production from high cost tight oil (fracking) requires $75 per barrel (basis WTI crude). As a corollary to this, if prices were to decline below $75 per barrel, production from high cost tight oil (fracking) could decline and prices lower than $75 may, over the short term (1-3 years), hurt the US economy. In summary, lower oil prices are neutral to the US, so long as prices stay above $75 per barrel. Prices below $75 may be negative to the US economy.

*2. The big sign effect - consumer price psychology: A further caveat is the sentiment effect. Almost everyone in the US is aware of the price of oil due to large government mandated signs at refueling stations. If oil prices move below $3 per gallon at the pump (see chart below) then there may be an boost in consumer spending on non-oil goods due to pricing psychology which overwhelms the decline in revenue for oil companies.

*3. Shocks are unpredictable - speed of the price move: Consumers react to the speed of price movements in addition to the magnitude of the move. Oil prices halving or doubling in 6 months generates a much different and more unpredictable reaction than oil prices gradually doubling or halving over 5 or 10 years.

[Summary: Lower oil prices in the 1990s and 2000s were almost always beneficial to the US economy, today they are neutral. Oil prices below $75 may be negative to the US economy.]

[For the sake of brevity and simplicity I am not including economic multiplier effects in the above.]

Where is the floor for the price of oil?

Oil prices (WTI crude as a proxy) are close to $90 per barrel this morning, down from almost $110 earlier in 2014. $90 is also major trend line support (see chart below).

This is despite global unrest in Russia, Ukraine, Syria, Iraq and elsewhere. As I have mentioned before (see charts below or click link), wars over the past 30 years have generally been negative for oil prices, even when, and sometimes precisely because, oil producing and exporting nations are involved.

Over the short term (next 3-6 months) it looks like oil will continue to head even lower due to weakness in Chinese and EU oil demand and there are three levels which have to come into play to define the downside:

*1. Marginal Producers: At what price do the global marginal high cost oil suppliers, currently US tight oil (fracking) producers, begin to shut in supply and stall exploration activity? The general assumption is that this begins in the mid to low $70s per barrel (basis WTI crude).

*2. Consumers: At what price do oil consumers increase their consumption? Consumer behavior changes slowly over time with respect to oil - this is why oil demand is called inelastic. Oil prices have to go to extreme levels to change consumption behaviour - hence the rally to $150 in 2008 required to stall demand in the face of insufficient supply growth. So although lower oil prices will likely increase demand above historic patterns, this is likely to occur only over the longer term (3-5 years). So count this factor out for a hard floor level in the short term.

*3. OPEC: At what level will OPEC (which just means the Saudis these days) act? The Saudis already say they are cutting supply. However, they are still only matching reductions in demand growth and have yet to get ahead of the curve. The Saudi budget break-even is currently in the high $70s per barrel. This is the level below which the government there has to start borrowing money to pay for schools, roads, defense and so on.

So the mid to high $70s may be the first floor to be tested. That is the level at which US tight oil producers and OPEC (Saudis) have to begin reacting by cutting supply to match the lack of robust oil demand growth.

US Energy Stocks Turn Red on Russian Sanctions

There were a slew of new sanctions against the Russian oil industry announced this morning by the US and EU. So why isn't oil rallying? And why are US energy stocks being hit?

Why isn't oil rallying on sanctions that could cut oil supply? Because the International Energy Agency (IEA) on Thursday reduced its forecast for the rise in oil demand this year for the third month in a row. European and Asian demand weakness are the main causes. The IEA expects global oil demand to grow by only 0.9 million barrels a day in 2014, down 65,000 barrels a day compared with last month's forecast and lower by 300,000 barrels a day since July.

Furthermore, according to the IEA the Saudis (the only OPEC country willing to cut production) reduced oil production by 330,000 barrels a day in August and are now producing at their lowest level since 2011. However, they are merely matching falling demand and so this cut in supply is not bullish for oil prices.

The Russian story is still very bullish over the longer term and if you look at longer dated oil contracts (December 2018, for example) the oil market is up almost $2 per barrel this week.

So the short term bearish outlook for oil continues, but longer term (2+ years) these Russian sanctions are fairly bullish for oil prices.

Why are US energy stocks down today? Because oil is a global industry with many US oil companies investing in Russian oil production. Russian oil companies also use US oil services companies for exploration and production. Sanctions cut both of these revenue sources.

[ Market Cap Changes today of Energy Sector of US S&P 500 ]

Oil market calling end to US tight oil (shale fracking)

There was an interesting article today on an oil trader betting that the US tight oil (shale fracking) boom will end soon.

The oil market appears to supports this thesis.

The front of the oil curve continues to sell off, while the back end (January 2015 onwards) is rallying.

Short term weakness in oil futures is likely to continue for balance of this year due to the bump up in US oil supply. However, despite this short term price weakness, longer term the market is saying that this new supply will be insufficient.

Production of $15 oil began to decline back in 2005. Oil producers since 2005 have shifted up the supply cost curve in order to produce more oil.  Fracking, Canadian oil sands and ultra deep offshore are all $50+ per barrel sources that had to be tapped to make up for the decline of $15 oil.  These three sources are very difficult to scale quickly due to cost and complexity and the market is telling us that they may not add enough supply to offset the decline in global $15 oil production.