In several of our publications we have highlighted how important the oil price is in relation to investments, input prices for manufacturers and household spending for UK consumers. Even though we are in the top 20 of oil producer countries, we are a net importer since the North Sea production cannot satisfy internal demand. With the price rising, tensions and political changes in the Middle East, it’s now time to talk again about it, as we did back in November 2014, when we published an article about the new dynamics of the oil market.
Securing deals, closing the tap, and fixing the budget
In the last year Opec, the organisation including 14 of the major oil producer countries, led by Saudi Arabia has decided to curb the oil supply for a prolonged period after a three-year market downturn. In November, this decision, also backed by 10 non-Opec countries led by Russia, has been extended for the entire 2018.
Markets reacted as expected and Brent price went up to reach 62 US Dollars per barrel, a much higher price compared to US$ 43.6 - which was the 2016 weekly average.
The alliance between the Saudis and Russia has been considered not so stable in the past, however it might hold fine this time. One of the reason is highlighted in the graph below.
The rating agency Fitch’s calculated what level the oil price would need to be for several countries to be able to break-even on their fiscal budgets and it looks clear that Saudi Arabia and Russia’s interests converge at a similar price.
In the recent past, both countries experienced some difficulties related to the low oil price. In 2016 the Saudis, for the first time ever, issued a government bond to finance their budget and they had to do it again twice in 2017. They have also introduced some (small) taxes for individuals who used to pay no taxes at all. The country has still plenty of reserves but they felt the urge to end a period of low oil revenues.
On the other side, Russia is recovering from a quite long period of sluggish growth and recession with high pressures on the Ruble in particular during the period between 2015 and 2016. A higher oil price will definitely drive the country towards economic stability and recovery in an historical period where the eastern country likes to flex its muscles.
2014: a “fracktured” market
The “fracking” revolution dramatically changed the oil market in 2014 with the US being able to raise its production to a level close to the one of Saudi Arabia and Russia. At that time Saudis and the other Opec countries accepted the challenge and, in order to keep their market share, increased the production of crude oil. This move contributed to the price collapse. The hope was to kick out some shale producers with a price too low to be able to survive.
What predicted actually happened. A sharp drop in prices kicked out the least productive oil rigs, however the overproduction did not just have the effect of slumping prices but also of creating a high level of oil stockpiles, which are still a buffer against low production.
Will the US close the gap?
During the meeting with Opec, some non-Opec countries expressed concerns about production being too low. Even if there is a lower number of rigs currently active in the US, American shale producer may be able to increase their production quickly enough to satisfy a growing demand coming from a world experiencing a synchronized economic expansion.
The data below confirm that the US producers can react pretty quickly to higher oil prices and higher demand, however not as quick as Saudi Arabia which, according to their own declarations, have spare production capacity of two million barrel per day which can be almost immediately used without the necessity of new rigs.
Is the price plan going to hold?
Well, this is the million dollar question. A price around US$ 60/70 may satisfy most of the Opec countries, Russia, and also US shale producers, so it may actually hold. However the oil game is not just about economic fundamentals: it is about politics and stability in the short run and about new technologies and environmental issues in the medium and long run. Its importance may decrease in the long run, but it’s still an interesting game.