Low oil prices having forced some producers out of business, WTI and Brent oil prices edge up as the oversupply shrinks

Six reasons why oil prices reached new 2016 highs

Crude oil was at a 13-year record $25 low in mid-January 2016 and has soared more than 70 per cent since. The battle is on again. We are talking about the mighty forces whipping up the oil prices. How does the investor work out where the oil price will go? Ultimately, you have to make your own forecasts, at least on the general, long term direction of oil prices - short term movements tend to be driven by news stores on the day. In particular, you need to take into consideration the following dimensions:

- Supply and demand: if producers are outstripping demand, prices will fall and if there is a shortage of oil, prices will rise.
- Political events: a war, rebellion or political uncertainty affecting major oil producers may prevent those countries from producing and selling, reducing the supply of oil.
- Economic growth: if demand is expected to grow faster than production, excess supply will be soaked up and shortages will arise.
- Related markets: the futures market, availability of transport, currency rates and the cost and of extraction equipment and labor can all affect the price of oil.

We took these factors into consideration when assessing six reasons for the recent rise in crude oil prices. Will this rally continue, or has the price peaked?

Weaker dollar raises oil prices

The market price of crude oil is valued in US dollars. Therefore, when the oil price falls or rises, you also need to look at the value of the dollar against a range of currencies. If an oil refinery in China needs to buy crude oil, it has to convert its income, derived in the local currency, Yuan into dollars. An oil producer, such as Saudi Arabia, needs to convert its income into the local currency, the Riyal in order to cover its costs. Large buyers go direct to suppliers in order to get a good price for their oil. China is particularly adept at this practice and has written up agreements to pay in its own currency for crude oil, rather than in dollars. So, if the value of the dollar falls by 10 per cent, the contract price of those agreement rises by 10 per cent, even though it hasn't changed at all in the contract currency.

In fact, this phenomenon is notable in all commodities priced in dollars - steel, copper, gold, and silver have all experienced price rises in 2016. This is not because there is a shortage in those commodities; it is just because the currency in which they are priced has fallen.

To start with, oil prices rose in tandem with the decision of the Federal Reserve to keep its federal funds rate unchanged, prompting the dollar to fall. In a record of sorts, this is the third time the Federal Reserve left the rates where they were. The last hike was way back in December.

Subsequent to the decision, the Brent crude futures hit a new high of $47.19 per barrel. Brent, in fact, spiked nearly twenty percent in April, the largest monthly gain in 2016. For its part, the WTI too hit a 2016 high at $45.33. To put things in perspective, Brent was trading at just $26 a barrel at the start of 2016. That begs the question, how does a Federal Reserve rate impact the oil prices? Well, the answer lies in the alliance between interest rates and weak dollar. As we know, crude is traded internationally in dollars. If the dollar goes down versus other currencies, oil prices follow suit. That's because a weak dollar makes commodities traded in it cheaper in the market, and all the more attractive and affordable for traders holding foreign currencies like Euro.

Alongside, the Federal Reserve also stopped referring to risky world financial conditions, thus implying improved market status. As such the Federal Reserve is expecting the world economies to pick up and use more oil to produce and for exchanges. Similarly, the World Bank also raised its forecast of crude oil prices to $41 per barrel in 2016 from its earlier estimate of $37 per barrel .

US oil inventories and storage space

In mid-April, the American Petroleum Industry reported a significant drop in deliveries to oil storage facilities and this information was echoed by the Energy Information Administration. Market reporters seized on this news as a sign that the excess of oil available on the market was reducing. Those headlines caused the price of crude oil to rise by 5 per cent in two days. What the news reports didn't explain was that collections from the storage tanks drop even further than delivery levels, resulting in record levels of oil in storage - which indicates that the supply of oil is exceeding the demand for oil at an even greater rate than even before. That storage factor caused one of the largest rises in the price of oil in April - on inaccurately reported information.

As with the currency market, the trade in storage space can impact the price of oil. If all available space is full, no one can store up new oil production. As with any market, shortage of space causes the cost of storage to rise. Higher storage costs reduce the incentive to buy now, and increases the futures price of oil to near-contango. The traditional message of the futures market is that it indicates the direction of spot oil prices. Speculators read the forward price of oil as though it says "this will be the price of oil in 3 months time." In fact, it is saying "this is the cost of buying oil now and storing it for 3 months."

Everyone knows that there is an excess supply of oil and that prices will not rise until that excess disappears. So, market analysts watch the utilization of oil storage in the United States very closely. This has become an indicator of where the price of oil is going.

Oil Production

In the US, overproduction is tapering off. Between 2010 and 2015 there was a wave of a shale oil boom in the US. From importing over ten million barrels a day, shale provided energy security helping reduce imports. During what oil-price.net dubbed "the American oil revolution", domestic crude oil production reached a record high of 9.3 million barrels per day. Since then, US oil production has dropped - nearly 6 percent in the last year alone. The present drop in production is the lowest since September 2014 as output stands at 8.8 million barrels per day, shaking off about 113,000 barrels per day. Oil production in Eagle Ford shale basin in Texas declined three percent in March while output from Bakken shale in North Dakota sagged by two percent in February. We forecast previously that few fracking companies relying on $70/barrel oil would be able to weather cheap oil for a long time. Some have maintained production at a loss; some brilliantly reduced maintenance costs. However, in this kind of cheap oil intricate environment, time is the enemy. Many have gone under resulting in a reduction of oversupply.

So far, 60 oil and gas companies in the US have declared themselves bankrupt. Why? Shale wells have a high depletion rate. Depletion can commonly be 45 percent a year for fracked wells (vs. around 10 percent for classic wells). By the numbers this means that after one year a fracked well produces on average 55% of what it did on day 1. After 2 years remaining production has plummeted down to 30%, or less than 1/3 of initial output. And at 12 million dollars a pop, new wells are not cheap.
Whereas $70 oil prices allowed financing a "rolling mat" of wells in various completion stages to provide a continuous supply of oil to compensate depletion, things are entirely different now that oil is in the $40 range.

Although innovative financing methods meant that frackers already had their financing and output contracts in place for new wells drilled throughout 2015 and 2016, that source of funds has now dried up, resulting in a near-cessation of new well drilling. This feeds through into a lower number of overall wells in the USA as older wells are not being replaced. So understandably, with investment in new wells dwindling, few new wells were drilled. We are now 2 years into the sub-$50 oil price range and as the above numbers illustrate, the compounded depletion is making itself felt. The existing wells are rapidly producing less and less and what used to be US oversupply flooding the market is no more. Naturally, the imports are rising again to offset the falling production thus pushing up the price of oil, as of late.

Disruption in supplies

Channeling the ground realities, disruption in oil supply across the world as a result of terrorism, strikes, sabotage or lack of maintenance are all sharp reasons for price fluctuations. In all, "unplanned disruptions" accounted for a loss of about 2.5M b/d. Evidently, this is rarely reported, but when oil prices are low expect more disruption. This has more to do with human nature than economics. With oil revenues down, oil producers cut corners and reduce staff levels. Maintenance becomes comparatively expensive and in some parts of the world (even in the US, we're looking at you BP) it is simply postponed, turned into technical indebtedness.

Routine safety checks are not performed and lapsed. Record-keeping becomes sparse. People are laid off resulting in fewer people operating the same rig under now unsafe conditions. Also low oil prices depress local economies due to the loss of jobs and just less money going around. When resentment towards oil companies and desperation sets in, acts of sabotage are common. So it comes as no surprise that disruption in any oil operation is more likely following periods of low crude prices.

Supply disruptions across the world dipped investor confidence. In Brazil, a fire broke out at P-48 off shore oil platform, putting it out of production. In this case, it's alleged that safety concerns were repeatedly ignored. In Ghana, several off shore platforms are offline for maintenance.

At one point in time, estimates in Kurdistan were put at 45 billion barrels of oil. True to the hyped estimates, Kurdistan emerged as an important player helping Iraq's output to increase by 3.99 million barrels a day. Yet, with the emergence of ISIS, the region has become chaotic, to say the least. This February, oil exports from the region were halted due to attacks on pipelines through Turkey. Production in Northern Fields operated by Iraq's National oil company remains in doldrums because of political tensions with the Kurds. A worker's strike in Kuwait forced the Gulf state to reduce its oil output. The three day strike wiped out 1.5 million barrels from the daily production. Indeed, that's roughly equivalent to the 'overproduction' of oil in the world today. Since the refining operations too were affected, traders reacted to the strike by buying more oil on the following Monday. Further, a pipeline fire in Nigeria affected the flow of 142 kb/d of crude. Apart from this too, Nigeria has been plagued by supply disruptions. Pipeline disturbances in Iraq and Nigeria removed more than 800,000 barrels of crude a day off the market, contributing to about two percent of oil price rise last February.

Staying with Kuwait, Brent gained from the news that Saudi Arabia and Kuwait were still unclear over the start of Khafji oilfield. In March, both the countries agreed to restart production in the field that produced 280,000 to 300,000 barrels per day. To look back, the oil field was closed in 2014 over environmental concerns. Much more so, the news has injected hope of shaving off the glut that persists.

Finally there are justifiable concerns over disruption in Canada's oil supply due to wild fires. Many of the pipelines have been shut down as precaution and decline from the region is but expected.

Volatility of the market

Plain volatility has markets acting defensively. We have previously reported on the current record volatility in oil prices. Volatility makes traders nervous, pushing the prices to higher margins because of geopolitical factors. OPEC countries are hurting because of budget deficits. It may be their own fault to use their oil dominance and it may be biting them back to be still relying on oil to fund everything. For the first time since pretty much anyone alive can remember, OPEC countries have to tighten their belts. And, as we mentioned before there are strikes in Kuwait. Venezuela, member of OPEC since 1960, is hurting so bad it can't keep the lights on and declared a 2-day workweek to save electricity. The cash crunch and crumbling infrastructure in Venezuela is a major worry for OPEC's production.

Also OPEC is getting more and more serious about limiting output - so much so it invited outsider Russia. Earlier OPEC gathered in Doha, Qatar to come to an agreement on production cuts with Russia. A prospective cut in production sent the analysts in a tipsy with a rally of 5 percent. Predictably Russia did not appreciate that state-owned Saudi Aramco had sold crude to Chinese refineries, asserting its dominance over Russia and Iran. And so, in typical OPEC fashion, the meeting ended in a stalemate - although the need to limit production remains on the table. So, the upcoming June meeting gains significance for a possible cut in production.

Saudi Arabia's shady outlook

As places like Saudi Arabia tighten their belts to avoid further crisis they will inevitably contemplate either levying higher taxes on their citizenry or cutting subsidies to balance their budgets. However if history teaches us anything, it is that taxation without representation doesn't work - not for very long. In short people who pay taxes want to have a say in how their tax money is used, universally. Saudi Arabia has zero income tax for that very reason: Saudis are placated with generous subsidies and don't typically complain about the near total lack of individual freedoms in the theocratic kingdom. But start levying taxes and they will - like anyone would - demand to choose how it is spent.

Given that the Saudi kingdom's legislative, judiciary and executive systems are entirely based on religious writings unchanged since the 6th century, any reform won't happen overnight. But time is of the essence for Saudi Arabia who has already liquidated $140 billion of its foreign reserves since the oil price plunged below $50 in 2014 and will run out of cash within 4 years if oil prices stay there.

Today relying on high oil prices to pay for everything is coming back to haunt Saudi Arabia who desperately needs $86 oil to balance its budget. So to stem the hemorrhage of cash, the Saudis are planning to create a new wealth fund whereby state-owned companies like Saudi Aramco will be imbibed into, so that it would be easier to invest inside Saudi Arabia thus attracting foreign capital.

This move is part of a larger ambition to foster entrepreneurship in Saudi Arabia with major projects such as the King Abdullah Financial District hosting 73 high towers connected with a speed train. But after decades of living on government subsidies, transitioning into a competitive workforce promises to be a bit of a rude awakening for Saudis who make up one of the highest paid, least productive workforce in the world. As one CEO stated: it is "a serious battle trying to get those that they hire to actually do anything" which explains why over 90% of Saudi private companies hires are foreigners.

Whether Saudi Arabia can actually achieve its goals of promoting enterprise and creativity, while remaining autocratic remains to be seen. Generally, freer more socially accepting societies are needed to encourage free enterprise

Furthermore there is a bill in the US congress known as the Justice Against Sponsors of Terrorism Act (JASTA), that will, if passed, allow the families affected by the 9/11 terrorist acts to sue the Saudi Government (15 of the 19 hijackers were Saudi nationals). This would be a very public slap in the face for the Saudis who in retaliation have threatened to sell billions worth US assets. And they may have to liquidate these assets rather quickly: if found connected to terrorism by a court, these assets can be seized by the US Federal Government; if so these assets would instantly evaporate from the Saudis books.
Regarding the Saudi Aramco IPO, valuation will be tricky to establish as the company's oil reserves are considered a state secret which no foreign expert is allowed to audit, prompting many to accuse the Kingdom of grossly overstating these reserves. Foreign investors would also be exposed to the Saudi government re-nationalizing Saudi Aramco on a whim, like it did in 1980. Both the timing and lack of transparency in the Saudi Aramco IPO are reminiscent of the Enron IPO.

As oil prices continue rising, Saudi Arabia may be able to buy more time to take more steps towards the reforms needed by a productive society. In any case once they start levying taxes or cutting subsidies, the result will be identical. Saudi citizens will likely demand more rights: the right for representation in the case of taxation and the freedom of enterprise to provide for their families if subsidies are cut. In both cases more unrest and oil price volatility.

Right now, the "smart money" is avoiding Saudi Arabia altogether: not a single major western financial institution has opened office in any of the 73 tours of the new King Abdullah Financial District. Understandably it would be disastrous for any western bank to come under scrutiny from the Justice Against Sponsors of Terrorism Act. But there is more to it: Saudi Arabia just does not have a viable plan B for after it runs out of cash 4 years from now, and the "smart money" is wondering who will control Saudi oil reserves by 2020.

Conclusion

All the reasons given above may be distilled but are not marked in perpetuity. Much more so, they are imprinted with nifty dissolutive variables. Yet, it's undeniable that there's resurgence in the price of oil. From geo-political to market forces, the reasons are indeed varied as we've touched upon. And while the effects of the ongoing fires in Canada are yet to be known, they aren't going to bring down the price of oil. The OPEC meeting on June 2 can.