There are some that anticipate (and hope) that crude oil markets are starting to rebound from the abysmal price deflation seen over the past 18 months. This optimism, however, is not supported by the fundamentals. Since March, crude oil prices have increased by 4.5% (see the chart on page 10), driven in large part by the expectation that OPEC, along with Russia, would consummate a deal “capping,” but not reducing, crude oil production at current levels. Markets have been anticipating that this agreement, which was supposed to have been executed in Doha on April 16, would start a market correction that will bring crude oil supply and demand back into balance.
Yet the Doha meeting failed to generate an accord and may have incented one producer (Saudi Arabia) to start doubling down on its current level of production in hopes of maintaining market share at the expense of its obstinate Persian Gulf nemesis, Iran. Regardless, what markets failed to appreciate, or have wishfully ignored, is that even if the agreements had been successful (or materialize in some future agreement) they would have done (will do) very little to alleviate the excess supply in world crude oil markets for a variety of reasons.
First, most OPEC producers are already producing at relatively high or near record levels. Saudi Arabia, for instance, is already producing over 10 million barrels per day (MMBbls/d). More importantly, Iran, free from the shackles of sanctions, has proven quiet capable of exceeding most analysts’ expectations of its near-term production capabilities. Iran is now producing as much as 3.1 MMBbls/d and will continue increasing production until it reaches its pre-sanctions production level of 4.0 MMBbls/d.
Second, non-OPEC crude oil production, while down, continues to be resilient and defy conventional wisdom. Russia, which has indicated a willingness to collaborate with OPEC, is currently producing at post-Soviet era highs of around 10 MMBbls/d.
Third, even if the OPEC-based production “caps” were to hold, which itself was a big assumption, those caps would have done nothing to reduce the record levels of crude oil supplies that are in various forms of storage around the globe. The U.S. DOE reports U.S. crude oil storage at a record 80-year high. Thus, these OPEC-initiated production caps would have done little to reduce the copious amounts of crude oil being stockpiled in storage tanks, tankers, rail cars and other forms of storage around the world.
Lastly, and most importantly, any meaningful crude oil price rally will likely sow the seeds of its own destruction since U.S. producers have aggressively restructured their operating costs to levels that are 40% to 50% of their pre-crash level. This effectively re-calibrates the break-even price for many U.S. producers to levels that are a fraction of earlier-observed levels. Thus, any price rebound that starts to encroach $50 per barrel will likely stimulate additional production, particularly from unconventional wells that have been drilled but not completed and can be brought into production quickly. The resulting production increase will lower prices once again.
David E. Dismukes is the executive director of the Center for Energy Studies at LSU.
Originally published in the second quarter 2016 edition of 10/12 Industry Report.