ShareTweet+ 1Mail
The conflict between OPEC and U.S. shale/tight oil producers has entered a new phase. And the result has been an accelerated decline in oil prices.
Last November (on Thanksgiving no less), Saudi Arabia led an OPEC decision to hold production stable, followed by a later significant increase in volume. For the first time, the cartel had opted to protect market share rather than price.
This certainly did not serve the interests of some OPEC members – Venezuela, Nigeria, Libya, Iran – who require much higher prices to balance unwieldy central budgets
The primary opponent was the new source of oil in the market – unconventional production from North America, the U.S. in particular. Thereupon began a tug of war that has largely determined the range of oil pricing variation over the past eight months.
This is what is strange about all of this. Essentially, the same market conditions prevail today as existed a year ago when crude oil was exceeding $100 a barrel. In fact, global demand is higher now than it was last July and accelerating. The price, on the other hand, has been cut in half.
To be sure, there is excess supply on the market (thanks to the remarkable recovery of American production, now at levels not seen in 40 years), and a correction was in order even without any OPEC move.
But that correction was more in the order of a decline to the low $80s or mid $70s. That has gone down much further because of what outside pressures have done to the trading environment.
Here’s my take on the international scheme to keep oil prices down…
The Big Players Still Play Dangerous Shorts
As I have noted here in Oil & Energy Investor on a number of occasions, the interchange between “paper barrels†(futures contracts) and “wet barrels†(actual consignments of oil) has been undergoing some major changes. It is the financial contract, not the allotment of crude, that drives the market.
When prices begin showing weakness, the manipulation turns to shorting oil. A short is a bet that the price of an underlying asset will decline. Control of a commodity (or stock shares, for that matter) is acquired by borrowing from a dealer. What is borrowed is then immediately sold. The short seller later returns to the market, buys back the asset, and returns it to the original owner.
If the short seller is correct (or has manipulated the market through huge positions to make it correct), a profit is made. Take this simple example. A futures contract in oil is obtained at $70 a barrel and sold at market. When the contracts are reacquired (i.e., the short seller buys at market to return the contract to its source), the price of oil has declined to $62. The transaction makes $8 a barrel (with the contract usually for 10,000 barrels), minus whatever small fee is paid for the right to use (temporarily) an asset actually held by somebody else.
Now, shorting is a component of the market. It remains quite dangerous for the average investor because there is theoretically no limit to how much you can lose if the value of the underlying asset goes up after the initial sale. It still must be bought back and returned, regardless of how much it has appreciated in price during the interim.
Some shorts are even more dangerous and are now limited or prevented by regulators. These involve running a “naked†short, a short contract without actually having the underlying commodity or stock to begin with.
Big players can sometimes do this by stringing together options and other pieces of derivative paper. Nonetheless, a really bad move here can bring down a trading house. For the individual retail investor, it is a direct way of losing the farm.
Two SWFs Have Been Shorting Oil…
But what if the underlying asset upon which the short is constructed – both its availability and amount – is under your control? What if you are shorting your own product?
Normally, this would be considered insane. Why deliberately reduce the price charged for your source of revenue? Why guarantee that you are going to be receiving less?
This makes sense only if the short is run for a different objective, one for which the short seller is prepared to take a price hit short term for more market control longer term.
Well, this is what OPEC nations have been doing at least over the past three weeks. Indications have surfaced from the volume and direction of paper makers in Dubai and on the continent that at least two Sovereign Wealth Funds (SWFs) from OPEC members have been shorting oil.
This is the latest stage in the competition with shale producers. By driving the oil price to below $58 a barrel, sources are indicating between 8 and 12% has been shaved off the Dated Brent benchmark price.
Brent is one of two major benchmarks against which most international oil trade is based. The other is West Texas Intermediate (WTI). Brent is set daily in London; WTI in New York.
…Depressing Brent Prices
Statistics for what shots are run in the U.S. are transparent. This is not the case in many other parts of the world. There, indication of movement is gained by what financing middlemen do.
As of Tuesday of this week, sources confirm that oil shorting contracts beginning on June 15 have increased markedly from Persian Gulf interests. Brent prices have declined 13.8% in the six weeks that followed.
According to sources cutting the paper, primary among the short contracts sold and purchased has been action sponsored by two of the largest SWFs in the world: SAMA Foreign Holdings (Saudi Arabia) and the Kuwait Investment Authority. In each case, financial intermediaries are used for the actual transactions. Other SWFs are suspected.
It is certainly possible that an SWF may short oil merely as a revenue-gathering device. After all, such funds are investing excess capital to gain a return and they exist all over the world.
But short sales are rather uncommon with these huge outfits; they would rather have longer-term returns from less volatility instruments.
Both of the SWFs identified obtain their funds from oil sales. The shorts constitute undercutting their own profits. However, the objective here is not to gain a return. They are, after all, assuring a reduced revenue flow from the very asset providing their own funding.
Why the Funds Are Playing This Game
This is a policy decision, not a fiduciary one. It is intended to drive the price down, prompting the closure and/or reduced operations of primary oil production competitors. And it is likely to have the intended affect as we move into unsustainable debt loads for many American shale producers, rising bankruptcies among smaller operators, and a resurgence in the M&A curve.
The shorts guarantee a loss of income but are orchestrated for other reasons. Obviously there are other shorts being run by interests having nothing to do with OPEC. In fact, as the major short positions emerge, it makes it that much easier for others to follow suit.
OPEC is proving a point by (at least in the short term) shooting itself in the foot to clear out competitors.
Short positions need to be unwound and settled. This will happen quickly. The Saudi Oil Ministry announced yesterday they expected the dip in crude prices to be ending soon.
Easy enough to say when major crude providers have been driving prices of their own product down all along.
ShareTweet+ 1Mail
The conflict between OPEC and U.S. shale/tight oil producers has entered a new phase. And the result has been an accelerated decline in oil prices.
Last November (on Thanksgiving no less), Saudi Arabia led an OPEC decision to hold production stable, followed by a later significant increase in volume. For the first time, the cartel had opted to protect market share rather than price.
This certainly did not serve the interests of some OPEC members – Venezuela, Nigeria, Libya, Iran – who require much higher prices to balance unwieldy central budgets
The primary opponent was the new source of oil in the market – unconventional production from North America, the U.S. in particular. Thereupon began a tug of war that has largely determined the range of oil pricing variation over the past eight months.
This is what is strange about all of this. Essentially, the same market conditions prevail today as existed a year ago when crude oil was exceeding $100 a barrel. In fact, global demand is higher now than it was last July and accelerating. The price, on the other hand, has been cut in half.
To be sure, there is excess supply on the market (thanks to the remarkable recovery of American production, now at levels not seen in 40 years), and a correction was in order even without any OPEC move.
But that correction was more in the order of a decline to the low $80s or mid $70s. That has gone down much further because of what outside pressures have done to the trading environment.
Here’s my take on the international scheme to keep oil prices down…
The Big Players Still Play Dangerous Shorts
As I have noted here in Oil & Energy Investor on a number of occasions, the interchange between “paper barrels†(futures contracts) and “wet barrels†(actual consignments of oil) has been undergoing some major changes. It is the financial contract, not the allotment of crude, that drives the market.
When prices begin showing weakness, the manipulation turns to shorting oil. A short is a bet that the price of an underlying asset will decline. Control of a commodity (or stock shares, for that matter) is acquired by borrowing from a dealer. What is borrowed is then immediately sold. The short seller later returns to the market, buys back the asset, and returns it to the original owner.
If the short seller is correct (or has manipulated the market through huge positions to make it correct), a profit is made. Take this simple example. A futures contract in oil is obtained at $70 a barrel and sold at market. When the contracts are reacquired (i.e., the short seller buys at market to return the contract to its source), the price of oil has declined to $62. The transaction makes $8 a barrel (with the contract usually for 10,000 barrels), minus whatever small fee is paid for the right to use (temporarily) an asset actually held by somebody else.
Now, shorting is a component of the market. It remains quite dangerous for the average investor because there is theoretically no limit to how much you can lose if the value of the underlying asset goes up after the initial sale. It still must be bought back and returned, regardless of how much it has appreciated in price during the interim.
Some shorts are even more dangerous and are now limited or prevented by regulators. These involve running a “naked†short, a short contract without actually having the underlying commodity or stock to begin with.
Big players can sometimes do this by stringing together options and other pieces of derivative paper. Nonetheless, a really bad move here can bring down a trading house. For the individual retail investor, it is a direct way of losing the farm.
Two SWFs Have Been Shorting Oil…
But what if the underlying asset upon which the short is constructed – both its availability and amount – is under your control? What if you are shorting your own product?
Normally, this would be considered insane. Why deliberately reduce the price charged for your source of revenue? Why guarantee that you are going to be receiving less?
This makes sense only if the short is run for a different objective, one for which the short seller is prepared to take a price hit short term for more market control longer term.
Well, this is what OPEC nations have been doing at least over the past three weeks. Indications have surfaced from the volume and direction of paper makers in Dubai and on the continent that at least two Sovereign Wealth Funds (SWFs) from OPEC members have been shorting oil.
This is the latest stage in the competition with shale producers. By driving the oil price to below $58 a barrel, sources are indicating between 8 and 12% has been shaved off the Dated Brent benchmark price.
Brent is one of two major benchmarks against which most international oil trade is based. The other is West Texas Intermediate (WTI). Brent is set daily in London; WTI in New York.
…Depressing Brent Prices
Statistics for what shots are run in the U.S. are transparent. This is not the case in many other parts of the world. There, indication of movement is gained by what financing middlemen do.
As of Tuesday of this week, sources confirm that oil shorting contracts beginning on June 15 have increased markedly from Persian Gulf interests. Brent prices have declined 13.8% in the six weeks that followed.
According to sources cutting the paper, primary among the short contracts sold and purchased has been action sponsored by two of the largest SWFs in the world: SAMA Foreign Holdings (Saudi Arabia) and the Kuwait Investment Authority. In each case, financial intermediaries are used for the actual transactions. Other SWFs are suspected.
It is certainly possible that an SWF may short oil merely as a revenue-gathering device. After all, such funds are investing excess capital to gain a return and they exist all over the world.
But short sales are rather uncommon with these huge outfits; they would rather have longer-term returns from less volatility instruments.
Both of the SWFs identified obtain their funds from oil sales. The shorts constitute undercutting their own profits. However, the objective here is not to gain a return. They are, after all, assuring a reduced revenue flow from the very asset providing their own funding.
Why the Funds Are Playing This Game
This is a policy decision, not a fiduciary one. It is intended to drive the price down, prompting the closure and/or reduced operations of primary oil production competitors. And it is likely to have the intended affect as we move into unsustainable debt loads for many American shale producers, rising bankruptcies among smaller operators, and a resurgence in the M&A curve.
The shorts guarantee a loss of income but are orchestrated for other reasons. Obviously there are other shorts being run by interests having nothing to do with OPEC. In fact, as the major short positions emerge, it makes it that much easier for others to follow suit.
OPEC is proving a point by (at least in the short term) shooting itself in the foot to clear out competitors.
Short positions need to be unwound and settled. This will happen quickly. The Saudi Oil Ministry announced yesterday they expected the dip in crude prices to be ending soon.
Easy enough to say when major crude providers have been driving prices of their own product down all along.
Frackers getting hammered and facing credit line review in October. Saudis under pressure To change Policy. Believe We Will Have OPEC cut in December when Frackers are banjaxed
[link]
With An October date for Bank as assesment of credit lines To Frackers drawing closer it Would be Great To see WTI Go down into 30s. As Frackers suitability for loans Is based On asset values with Oil Price at circa 30 the Frackers are banjaxed. Expect to See US output at 9m And falling By Christmas. OPEC likely To cut production 2-3 percent thereafter
Will Saudi Arabia Cut Production For Iran? Why $70 Oil May Come Sooner Than You Think
Aug. 16, 2015 2:36 AM
Summary
• North American and Saudi production has peaked.
• Drilling costs in Saudi Arabia are increasing as cheap onshore supplies are exhausted, forcing the Arabian Kingdom to develop expensive offshore reserves.
• New Iranian oil has already been reflected in the spot price.
• Barring a surprise purposeful OPEC production increase of 2+ million bbl/day, oil prices should have at least stabilized.
• Higher prices are possible if OPEC cuts production for Iran.
Background
The past year has been a blood bath for oil prices. The descent started last September, when overproduction from the United States caused prices to dip to the 70 dollar per barrel range. The price later went down further as Saudi Arabia and OPEC decided to keep production unchanged in November 2014. Having halved in value from a year ago, prices have been in $40-60 range since January.
While most everyone agrees that oil prices should rise above current levels, the timing of this rise is uncertain. Some, such as Goldman Sachs, claim that oil will not rise above 50 dollars until 2020, while others, such as T. Boone Pickens, think that the next bull market may be right around the corner. While it is impossible to predict oil prices with a crystal ball, the overall projection can be estimated by taking a look at fundamental factors that caused the crash in the first place. There are two main factors behind the current crash: 1) production increases in U.S. and 2) OPEC's Decision to keep production unchanged.
U.S. Production
Earlier this year, I wrote an article regarding correlating historical rig counts as well as well production data to model production growth and estimate the date in which U.S. production would decrease and its effect on oil prices. Not much has changed since the writing of my previous article as things have mostly gone as planned: ex-rig counts have plunged and U.S. production has at least stopped increasing. Although the article/state data contradicts EIA data in that the article predicted production would peak in Dec.-April while EIA data predicted production increases until July, the overall consensus is the same: U.S. production has peaked. The production decline is not surprising, since oil prices crashed to ~$50/barrel large shale producers within the industry have stated that they will not increase production until the market is more balanced. Instead of increasing production, many of these companies such as EOG Resources (NYSE:EOG) have developed a backlog of such wells to releasing should oil prices stabilize around $65/barrel. The fact that the number of such uncompleted wells has increased from 285 to 320 in Q2 2015 (when oil prices were ~$60/barrel) is a good sign that shale companies such as EOG are serious when they say that they will not release the fraclog until oil reaches $65/barrel.
All in all, the poor Q2 exploration and production earnings combined with decreased rig count should lead to U.S. shale oil production cuts in H2 2015. This, combined with Saudi Arabian seasonal production cuts, should lead to stabilization of production in the U.S. and Saudi Arabia.
Will Saudi Arabia cut production?
While oil markets around the world were sent into a tailspin in November 2014 due to OPEC, this time may be different. U.S. shale is not part of OPEC but Iran is. It didn't make sense to cut production for a non-OPEC oil producer. However, it does make sense to cut production for another member of OPEC. Otherwise there is no point to continue having semi-annual meetings as the last few meetings have resulted in zero change. While significant hurdles remain, several factors will likely have large impact on the Saudi decision. These factors include but are not limited to: rising drilling costs in Saudi Arabia, energy independence/national security, and Iran's willingness to make political trades for economic relief.
Rising Drilling Costs in Saudi Arabia
It is well known that Saudi Arabia is one of the few places on earth where cheap oil still exists. Conventional onshore fields such as the Gharwar, Abqaiq, and Khurais are known to produce plenty of cheap oil costing below $10/barrel. However, what is not so well known is that Saudi Arabia has developed significant offshore oil production facilities. Offshore drilling is, by nature, more expensive than conventional onshore drilling, as this chart shows. Offshore shelf drilling, as done in Saudi Arabia, can break even if the cost is anywhere from $20 to $60 per barrel. Based on those cost estimates, it doesn't make sense for OPEC countries such as Saudi Arabia to flood the market with cheap oil as such an action would make their own offshore fields economically unviable.
Energy Independence - National Security
In additional to the higher costs involved with obtaining oil in this environment, it is also important to consider the fact that oil is also arguably the world's most important commodity. For national security purposes, every country wants some sort of energy security / independence. This means that countries with state owned oil companies will develop their own reserves even if oil goes to 10 dollars a barrel. This point is reinforced by the fact that, companies such as BP (NYSE:BP) and Petrobras (NYSE
BR) recently announced new deepwater drilling projects in spite of low oil prices.
No matter how much market share OPEC hopes to obtain by lowering prices, other countries will still develop their own reserves. Despite the intense rhetoric surrounding OPEC, recent seasonal production cuts from Saudi Arabia is a sign that OPEC favors stability over market share.
Political Trades in Exchange for Production Cuts
While national security is an important reason for OPEC not to increase production, one also has to consider the international relations in one of the most volatile regions of the world before deciding on oil prices. I'm not a political scientist, so I won't even try to discuss religious or political issues between Iran and Saudi Arabia. However, the fact remains that Iran was able to leverage nuclear limitations in order to obtain sanctions relief from the U.S. Likewise, the country should also be able to leverage proxy wars with Saudi Arabia in order to obtain a production cut. This kind of leverage could involve the trade of political concessions such as reduced support for Assad in Syria or Houthi Rebels in Yemen in exchange for a production cut from Saudi Arabia.
Conclusion
Most of the bad news has already been factored into the oil prices: U.S. production maxed out, Saudi/Russian production maxed out, and Iranian oil guaranteed to come to market in December 2015. Going forward we have declining or stabilizing U.S. production, Saudi Arabia production cut to 10.3 million Barrels per day, increased motor fuels demand due to lower prices, and possible further OPEC production cut to make room for Iran. While seasonally weaker demand from refiners and China's currency devaluation could push oil into the 30's, China is still increasing crude imports and the overall picture looks good. Worst-case scenario, oil will most likely stay within the $40-60/barrel range until mid-2016. Best-case Scenario, OPEC cuts production for Iran and we see $65-70/barrel by the end of the year.
All in all, the U.S. shale producers have learned their lessons regarding rampant production growth and have recently greatly scaled back operations. Furthermore, rising drilling costs in Saudi Arabia, means that the Saudis should have no incentive to let oil fall much more below current levels. Finally, Iran's willingness to compromise with the U.S. for economic relief is a good sign that they may also be willing to compromise with Saudi Arabia for similar economic relief. Nothing in the oil market is guaranteed, but should Saudi Arabia cut production for Iran, don't be surprised to see $65-70 oil sometime between December 2015 and June 2016.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in UCO over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Saudi Arabia is not going to continue pumping 1m barrels more and thus suffering huge losses on potential profits. Saudi is not a benevolent state looking to offer cheap oil to the whole World. Saudi needs oil to rise to enable it to balance Its budget and keep its population happy with subventions. Saudi Arabia has virtually no extra capacity to produce oil. Saudi Arabia Will do a Deal with Iran as it is in both their interests and deals Will be reached where proxy wars with Iran are being fought. Believe that Saudi Will look to move into refining business. Frackers, Canadian tar, deep sea oil all damaged as breakeven cost of production too high. Theses Will be the marginal producers but investors and oil companies will be wary of These projects for some time to come. World demand rising and supply will be reined in By falling project investment or agreement to limit production By Opec, Russia etc
Just Have To hold our nerves And conserve cash. This market Will turn and all the so called experts Will change their stories telling us that they had predicted the rebound. OPEC led By Saudi Arabia along With Russia Will cut production By between 1 and 2 percent. Saudi will Have crushed Shale and made space to allow Iran back into Market. Demand will rise approx 1,4 million barrels next year. Shale will decline next Year and Is already doing so now. Talk of productivity gains, cost reductions is nonsense. 1000 rigs less in US means less Oil production. October is the date for credit lines to highly indebted US fracking companies To be reassesed. With oil at 43 WTI and circa 290bn in outstanding debt who will provide additional loans. Rolling over existing debt is becoming even more difficult as can be seen By yields in secondary junk bond markets. Bankruptcy and takeovers likely with majors scooping up independents and finally putting control on silly US over production. Canadian tar. Deep sea Will also Take a hit. Also need to factor in natural declines 3-5 % on conventional oil fields plus cancelation of over 200bn in projects for future supply and all points to a recovery.
So they had circa 9m on hand Dec 2014 with 26m from placing. So that is 35m. 4 Million paid back to melody in june plus 6m for transocean, plus 3 million in deferred seismics, plus 2 million in interest payments for loan facility plus 4 million in salaries and expenses gives approx. 35 million - 19 million =16m. Lets say that they use another 6 million up to next June 2016. This leaves a hole of 10m. Thus let us hope that market sentiment better by June 2016 and a Barryroe Farmout concluded. If not there will be another placement for another 20M maybe may 2016. But if Oil rebounds and a deal done things may change