Comment: Sheikh versus shale
Growing shale output and stagnant oil demand in the Western world undermine the Middle East's efforts to restrict the global supply, and thereby stand in the way of the rise of crude oil prices, according to Julius Baer's Norbert Rucker
The “shale versus sheikh” debate captures today’s market environment accurately, and the short-term sentiment cycle shows how the opposing sides have periodically maintained the upper hand.
Sentiment was extraordinarily bullish in late 2016 and early this year, following the announcement of the Middle East’s supply deal, which nourished expectations of supplies tightening soon. By April, sentiment turned from bullish to bearish on growing evidence of a swift shale boom revival. Today, sentiment looks fairly balanced and the futures positions bear neither meaningful upside nor downside risks for prices.
We share the market’s concerns that the oil surplus will persist for longer and see oil prices trading sideways, spending more time in the high 40s than the low 50s. Particularly, growing shale output and stagnant Western oil demand undermine the Middle East’s restriction efforts.
The past decade’s super-cycle has irreversibly altered the oil market. Production costs have sustainably dropped, anchoring oil prices at a lower level. Shale’s inherent responsiveness on the back of its manufacturing-style operations makes today’s prices follow the cost anchor faster and more closely than they have historically. The market has entered a period of low-for-longer prices. That said, with the supply deal’s effectiveness increasingly questioned, we believe that downside risks for oil prices from an early and unorderly unwinding of the agreement have risen. Deeper cuts would only temporarily raise prices, while a change in strategy and re-focus on market share would aggravate the oversupply and pressure oil prices.
Persistent supply surplus
Despite the oil market’s economic relevance, there is a lack of reliable data and the global inventory picture remains blurred and opaque. Most market observers rely on the official US data, which provides an accurate and timely insight into the North American oil supply situation.
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The International Energy Agency publishes oil storage data for the western world but its updates are less frequent. Asia, and especially China, are blind spots and inventory levels can only be roughly gauged by combining production, trade, and refining trends. China’s storage capacity has grown substantially in recent years and today the country keeps more oil in storage than Europe. Reduced imports, strong exports, and strong refinery activity, caused a marked decline in US oil inventories in recent weeks, which led to expectations that the much-discussed market rebalancing is finally on its way. However, US refinery activity should ease from today’s excessively high levels, while the latest trends in China suggest that most of the imported oil went into storage.
Is the supply deal effective?
The increased questioning of the effectiveness of OPEC’s supply restrictions also fed the talk about exit options. The ultimate aim of the supply remains to lift oil prices and ease the pain from decreased petro-dollar revenues. However, the past months have shown that non- OPEC producers are comfortable with oil prices around US $50 per barrel, and that the shale industry in particular raises investments and lifts output.
This undermines the Middle East’s restriction efforts and bears market share losses. Quota compliance has been surprisingly strong so far, but the risks of slippage have increased. The persistent supply surplus, sideways-trading oil prices, and the incremental market share losses could eventually challenge the commitment to the agreement.
Finding a scapegoat to blame for non-compliance and to dismiss quota restrictions is the unorderly option to end the deal prematurely. This scenario frames our oil price bear case. The Middle East remains at odds with shale’s competitiveness and responsiveness. Market forces – rather than OPEC policy – ultimately determine oil prices, and these mechanisms have only grown stronger in today’s new oil world following the shale revolution.
Shale boom: frenzied drilling
US oil production growth has been pivotal to tame the initial supply deal euphoria, and lent support to the “shale” view at the expense of the “sheikh” view within the debate.
US oil production bottomed out earlier than expected last year and continues to grow faster than anticipated. The forces driving this are the ramp-up of Gulf of Mexico offshore projects and the shale oil drilling frenzy. Rig counts in the shale basins, the metric most widely observed to gauge drilling activity and investments, have more than doubled from last year’s lows. The Texan Permian Basin is the current shale boom hotspot, but drilling and production are also picking up in the North Dakotan Bakken and Texan Eagle Ford basins, revealing that the shale industry overall has a decent living in today’s oil price environment.
Understated oversupply risk
In all likelihood, long-term supply growth not only originates from shale, oil sands, or offshore sources, but also from conventional oil fields, based on policy change.
Companies responded to the downturn by trimming costs and cutting debt. Petro-nations have begun to mandate themselves a similar health treatment. With oil prices so far refraining from significantly recovering, and the supply deal not fully showing the desired results, decreased oil revenues remain a great economic challenge.
OPEC members – and particularly the Middle East, with Iran and Iraq in the driving seat – are set to grow oil output in the long run. The sustained shift in the cost curve anchoring oil prices at a lower level means that output growth is the only feasible option to raise government revenues. However, decreased petro-dollar income, and the challenges accompanying reform and policy change, create an environment of increased geopolitical risk, chiefly in the Middle East.