In the last 1 month, the price of Brent Crude has touched a low of $46/bbl and has currently moved up nearly 13% to touch a high of $52/bbl. Even as star oil traders like Andy Hall are turning bullish on the prospects of oil, there are still a lot of unanswered questions. The recent surge in the price of oil was largely driven by an OPEC arrangement to cut total oil output of the OPEC group. The reason analysts are positive about this arrangement is that Russia has also participated in this output cut arrangement. So what exactly does this leave the outlook for oil in the coming months?
How much will the OPEC nations share in output cuts
In the last meeting of the OPEC, countries in totality have agreed to cut output by 1 million barrels per day (bpd). This will be an average cut of nearly 1% in daily output. The big challenge is not agreeing to the cuts but ensuring that the cuts are equitably distributed among the members of the OPEC. For example, Iraq, Iran and Libya have sought exemption from this production cut as they had to face constant supply disruption due to sanctions on Iran and war in Iraq and Libya. While Russia and Saudi Arabia have agreed to this in principle, it is doubtful how smaller countries from Africa and Latin America will react to this. If countries go and expand output despite OPEC limits, then the entire idea gets defeated.
Let us not forget about inventories of oil…
The big challenge for oil is not the production of oil but the huge stockpile of oil. The OECD countries alone have oil inventories of nearly 3.09 billion barrels. With the daily supply of oil still being marginally above the daily demand for oil, the reserves are unlikely to be drawn in a big way any time soon. The bigger challenge is that the world is actually running out of storage space and that means the inventories will have to hit the market sooner than later. The inventory level is one factor that will keep a ceiling on oil prices. With over 70 days of oil inventory, it becomes much easier for countries to draw down on their inventories.
There is a massive supply of oil waiting in the sidelines…
This is topmost in the minds of most OPEC members. The US has shut down most of its shale production as it is virtually uneconomical for them to continue to produce oil at low prices. If the OPEC production cuts work and oil prices move up then the big beneficiary will be the US as its shale becomes profitable and it will be able to push more oil into the market. Remember, the US has already lifted its embargo on oil exports and it is in a position to flood global markets with oil. Over the last few years nearly $200 billion of investments in oil and gas have been put off due to weak oil prices. The US is one oil producer which has the capacity to increase oil production at very short notice. So any price increase will end up benefitting the US more than the OPEC. That is a situation that the OPEC and Russia will surely want to avoid at all costs.
How much longer can Saudi Arabia afford to produce less oil?
This is another important factor that will determine Saudi Arabia’s approach to oil output. Currently, the forex reserves of Saudi Arabia have fallen from a peak level of $750 billion in 2014 to around $520 billion in 2016. This drawdown has largely been on account of Saudi Arabia funding its budget deficit by drawing down its reserves. Currently, Saudi Arabia is drawing down nearly $9 billion of reserves per month. At this rate, the Saudi government will reach a critical level of reserves in the next 2 years. Saudi Arabia already has a fiscal deficit of 13% of GDP and it risks further downgrades. There are 2 options in front of Saudi Arabia. The first option is to hope that price of oil will rise and the higher oil prices will automatically reduce the deficit of the government. The reality is that the Saudi government does not have much time at its disposal. The second option is that Saudi Arabia continues to focus on market share and does not worry about prices. That will mean incurring further deficits. This will have to be matched by rigorous cuts in welfare and infrastructure expenditure. That trend has already begun and is only likely to get accentuated further. This will be a critical factor that will determine how much longer Saudi Arabia can sustain its production cuts.
Long term projections of oil are not too rosy…
If you consider the oil prices estimates of the IMF, World Bank and the Economist Intelligence Unit (EIU), none of them is predicting Brent Crude at above $72/bbl by 2024. A 20% appreciation in 8 years will mean that returns on oil will not even meet the cost of inflation in these economies. Prices of oil may be slated to remain low for much longer than was originally anticipated. This time it may actually be different!
While the final decision on oil quota cut will be taken in Vienna, OPEC will have to face the hard reality that they do not have much of a choice in this regard. Despite the support of Russia, oil may be headed in a weak range.