Can oil touch $70 / barrel in 2016; it must to save oil producers…

At a recent meeting of the OPEC, the views were divergent on the subject of whether the OPEC should try to regulate supply. But there was almost a unanimous consensus that a price of $70 / barrel would be ideal for the key OPEC nations across Middle East, Africa and Latin America to breathe easy.

Today the problems are manifesting at various levels. The Latin American nations like Venezuela are almost on the verge of default as oil revenues for their nation’s largest company, PDVSA, have shrunk with oil prices. Brazil has been hit by cheap oil and other commodities. African members like Nigeria and Angola have been vociferous for quite some time about curtailing OPEC supply and have started offering spot pricing to large buyers like India. Middle East, led by Saudi Arabia, seems to be the only segment of the OPEC which wants to continue supplying at lower prices. But that may have to change very soon. Here is why!

US shale capacity is shrinking rapidly…

The problem was always going to start with US shale. As prices plummeted, an increasing number of wells were made non-operational due to viability issues. Despite almost 55% of the shale wells being non-operational, the US oil output has been maintained. This is largely thanks to technology that enables shale drillers to inject greater amount of sand and increase the output per well substantially. But that is likely to saturate sooner rather than later.

Then there is the gargantuan US problem of funding through the debt route. Most of the shale projects have been financed through junk bonds and that has rapidly lost value in the US bond markets. A cursory look at the cash flow statements of the shale companies is enough to understand that most of them are generating negative cash flows. It is only a matter of time before someone calls out that “The emperor has no clothes”. Once that happens, the impact of US output and the squeeze on global output could be huge. And that could happen sooner rather than later. That must surely be music to the ears of the OPEC.

Cooperative role from non-OPEC players…

Of course, we are referring to large non-OPEC players like Russia and some key European nations. While Russia and OPEC have not got down to the negotiating table, the indications are rife that Russia may cooperate with the OPEC in oil pricing by regulating supply. Russia has already got into recession for the first time since 2009 and they realize that this is situation is hardly sustainable for too long. A weak rouble is not exactly helping boost exports due to weak demand from world markets.

For Russia the answer could be to unofficially cooperate with the OPEC and help them regulate global supply of oil. Remember if the OPEC produces around 30 million barrels of oil per day, then Russia itself produces close to 1/3rd of that. IN terms of daily production, Russian oil output is almost as large as Saudi Arabia. Obviously, if Russia and the OPEC combine, they would jointly account for half of global oil production and can have substantial impact in regulating supply and putting a floor on the price of oil. In that case, oil getting closer to $70 looks more likely. Remember, with Putin emerging as a saviour of the Shias in the Middle East, even Iran will be compelled to listen to the voice of reason emanating from Russia. For Russia, higher prices will come as a blessing in disguise. It will help them bridge their budget deficit and also pull the economy out of the rut of recession that it is stuck in now.

Middle East is running out of ideas on oil prices…

With oil prices ebbing for over a year now, the Middle East is surely running out of ideas. Initially, when prices were falling due to a glut of US shale, Saudi Arabia decided to focus on market share instead of price realization. The strategy would have worked perfectly if the US output had crumbled immediately. But one year is a long time and it has taken its toll on the finances of the Middle East. Saudi Arabia, which is the strongest among the Middle-East economies, is already running a fiscal deficit of 21% of GDP. That is a recipe for disaster. Saudi Arabia has been selling oil at below its cost and to bridge that gap it has been drawing down upon its huge forex chest of $750 billion. The rate at which Saudi Arabia is drawing down on its reserves, the IMF estimates that Saudi Arabia will be left with no cash in less than five years. Obviously, the vulnerability of smaller nations like Oman and Bahrain is much larger.

Countries like Saudi Arabia have very few options before them. They run a welfare economy driven by huge subsidies and government investments. That is clearly not sustainable. These expenses have to be sharply cut and it applies to other Middle East economies too. But the problem is something more elementary. The Middle East has no worthwhile industry other than oil. Hence cutting social expenses may not be as simple. The only option for the Middle East would be regulate the supply of oil and let oil prices move up.

To cut a long story short, the next year could see either some or all of the above stories play out. US oil shock is highly likely. Russia cooperating with Saudi Arabia may sound a little fallacious but politics and economics does make for strange bedfellows. But the most urgent thrust may actually come from the Middle East. High oil prices may be in their long term interest and nobody understands that better than them!

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