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Curious Case of Oil Armageddon

Part 1 – What is happening?

Last few months, newspapers are filled with predictions that oil prices are sinking. While some

predict a 20$ per barrel price, others compete to break even that figure and quote an incredible

15$ per barrel. There are still others who say there will be a rebound in prices to a 40$ level. (No

idea why our society craves for hysteria?)

Basically there has been too much chatter and I figured the best way is to ignore the chatter and

do my own study of the issue. I spent time last week studying some reports and looking at some

data and that has culminated into this blog post. In this post, as usual, I try to search for answers

that make sense from an economic standpoint. I've also spent some time thinking about the

behavioral angle of this crisis (this is in second part of this post). As with any other commodity,

market price of oil is a direct derivative of supply demand dynamics – let us analyze what exactly

is happening on both sides.

Demand Side

First, let me talk about the demand side. Again, main themes I get to read are, ‘Chinese economy

is slowing, Europe is not in a good shape’ – hence demand for oil is expected to be lower etc.

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Immediate questions to ask - Is this true or is it just an armchair hypothesis? If it’s true, the

extent of this demand drop is also important to consider.

IEA.ORG (International energy agency) has recently published a medium term Oil market outlook

and I’m attaching a few relevant excerpts from that report here:

“World oil demand growth in 2015 was 1.54 mb/d to average 92.92 mb/d. For 2016, global oil

demand growth is expected to be at around 1.26 mb/d, a little higher than the previous month’s

report, to reach 94.17 mb/d”

In other words, although demand growth itself is likely to fall (from 1.54 mb/d to 1.26 mb/d),

overall demand is expected to grow from 92.92 mb/d to 94.16 mb/d.

This is unlike all the negative commentary we hear which makes us believe that there is going to

be deep contraction in demand in 2016.

Report further goes on to describe effects of slowdown in Europe & China

“OECD Europe’s oil demand grew by 0.23 mb/d in 2015, while in 2016 oil demand is projected to

slightly decline by 0.01 mb/d compared with 2015”

“Chinese oil demand in 2015 grew by 0.37 mb/d, while oil demand in 2016 is projected to

increase again by 0.29 mb/d.”

In other words, so much talk in mainstream media about impending slowdown looks like air

bubbles to me.

Attached chart is a

quarter-wise global

oil demand chart

picked from data

available on IEA

(International Energy

Agency) website.

Source data available at

www.iea.org

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Demand side does not look like a problem to me – while slowdown certainly impacts the growth

in demand, this alone does not seem to explain the precipitous decline in oil prices and the

largely pessimistic outlook on the industry itself. Lets look further...

Supply side

Now this was really interesting – I think this is where the real answers lie

To begin with, I ask my readers to read this wonderful article by Clifford Krauss stating that Oil

Prices drop is because of supply side glut. He argues based on some beautiful charts that

NYTimes has mastered – article can be found here

Clifford Krauss NY Times article

A slightly older article but filled with interactive content can be found here:

Interactive NYTimes article

While I agree with Cliff’s arguments, I did not find a convincing answer to this aspect of price

drop – WHY NOW? And I wanted to validate his arguments by putting some numbers on the

table.

To summarize the main points in his article:

United States has doubled its production and it has become more self-sufficient to its oil needs

This means that traditional oil producing nations have to search for markets elsewhere. And this

has led to price war that threatens to bring oil prices down

OPEC is not slashing prices because it wants to retain its market share

Lets do our own homework and look at some numbers. First chart shows World Oil supply, taken

from same IEA source above:

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Source data available at www.iea.org

This chart below shows excess supply in each quarter

Source data available at www.iea.org

Next, we also look at the share of OPEC countries of the total oil supplied

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Source data available at www.iea.org

From the above data, we can make following inferences:

Non-OPEC supply is increasing

OPEC is holding onto its market share - so if Non-OPEC supply is increasing and OPEC responds by

retaining its market share of total oil produced, we can expect to have a positive feedback look.

Every barrel of Non-OPEC oil produced will add more than 1 barrel to the total oil produced

because of this feedback loop.

Supply outstrips demand by a couple of million barrels a day (approximately). This level of

demand-supply mismatch was found during the 1990 oil collapse.

If Supply is outstripping demand, then naturally, inventory is increasing. Which naturally leads to

a possibility that existing inventory might be low and hence nations are stocking up excess oil

supplied.

Inventory

Same IEA report also says that inventory levels are growing to unprecedented levels. Oil tanks

are filling up fast and currently USA has 70% of its capacity full. IEA estimates that the number of

days forward demand (a measure to look at inventory levels) are highest over a period of last 5

years. Attached below is days-forward demand covered by existing inventory levels (source is IEA

report)

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Chart shows that days-forward inventory globally is ~ 65 days whereas the 5 year average was

~59 days. That is almost a 10% increase. In quantity terms, total storage is ~300 million barrels

more than 5 year average level that was ~ 2700 million barrels.

A wildcard in this discussion is US's shale oil production - US has rapidly expanded its crude oil

production from 6 mbd in 2011 to 9 mbd in 2014, and this has spooked the Saudi Sheikhs to a

large extent. This has changed the existing patterns of oil supply forever (more on this later). NY

Times has put out this wonderful infographic on US crude oil production.

Source: New York Times

Coupled with all this is the fact that a new-kid is going to emerge on the block - IRAN. Iran has

just concluded a nuclear deal with other nations and is expected to hit the oil markets with a

bang (For those of you who don't know the context, Iran was banned from doing business

because of its nuclear threat). Iran is expected to add another 1 million barrel per day (note that

excess is already 2 million barrel per day) over next 6 months.

To conclude the first past of this discussion, key takeaways are:

Demand growth is sluggish and it is expected to grow slower than previous year. Although, price

fall does not look like a demand side issue

Oversupply of oil to the extent of 2 million barrels per day - this is significantly high and same

levels of demand-supply mismatch existed during 1990 oil collapse

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Inventories are at a record high levels across the globe

OPEC is continuing to keep its market share even when supply outstrips the demand - this is

creating a positive feedback loop for excess supply because Non-OPEC oil supply is on the rise.

Expectations of new player Iran entering into the ring increasing oil supply by a further 1 mbd in

short term

Economics 101 suggests that this situation can only have one outcome - a downward spiral of

prices. But this is more of an end effect - what is more important to ask is:

Why is there an oversupply? Why aren't markets self-adjusting?

Why isn't the OPEC doing anything? Why are they not cutting down production? What is at play?

What happens if OPEC let prices come back to 60$ per barrel?

PART 2 – How do we explain all this?

In this part, I explore reasons for the way events are unfolding in international markets. What

has led to this situation in the first place? Why is OPEC acting differently from the past where the

Sheikhs usually used to get together to cut down production. My answer – GAME THEORY. It’s

exciting to see how ‘Prisoners Dilemma’ is being played out right in front of our eyes. Let me

explain what I mean by this but before I do, I need to first list protagonists in this story – US (not

the US state, for a change, its US oil companies), Saudi Arabia & Russia.

For a quick overview of the problem, watch this Al-Jazeera video

Al-Jazeeera video

Let’s look at some facts first.

OPEC & its dynamics: As I discussed in my last post, Saudi Arabia led OPEC produces about

33% of total global supply. Within OPEC, following chart shows how each country stacks up in

terms of production:

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Needless to say, Saudi Arabia has disproportionately high leverage in decision making within

OPEC. It is more like Saudi says & others accept. What further increases Saudi’s leverage is its

reserve production capacity – Saudi has invested heavily to have a capability to produce an

additional 2 million per barrel on demand. So if any country tries to act smart, Saudi can just

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tighten the screws and make them fall in line. It further helps that most of these countries are

Muslim and Mecca is considered the fountainhead of Islam.

Let’s look at production levels of other countries. Top countries which account for global oil

production are listed below:

Oil production y-o-y growth

While, the above table is interesting, what is even more interesting is the growth in production

that each country has seen over past 5 years. I’ve listed production in Sep 2010 vs Sep 2015 for

major oil producing nations:

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You can see this trend more clearly in the following chart taken from IEA website:

From the above information, I can make following conclusions:

Barring Iraq, which has just come out of war, the country with a phenomenal increase in oil

production is the United States. Production of oil in the US has almost doubled among major oil

producing nations. In my previous post, I attributed bulk of this increase to Shale Oil production

Iran has seen a dramatic drop because of Sanctions and Russia & China’s production stagnated

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Shale Oil Production & How is it different from traditional drilling?

An important piece in this puzzle is also to understand how fracking (method of extracting shale

oil) is different from traditional oil drilling. I'm attaching an image built by Jim Scherrer to explain

the difference visually

As you can see, the difference is basically that Shale Oil drilling happens horizontally while

conventional drilling happens vertically. Without going into the technical jargon (which I myself

learnt in the last week), the implications of this new form of drilling are on the rate of depletion

of oil wells. While conventional wells deplete at 2-5% each year, that rate for Shale oil depletion

wells is much higher - a new well depletes almost 70% by beginning of year 3 (Source: Shawn

Tully article on Forbes here)

What this means is that Shale oil drillers need to continuously drill new wells to keep consistent

levels of production. Unlike a conventional well, a shale oil well has high marginal cost of

production because you need to keep digging. A conventional well, once setup, consistently

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pumps oil for a long period (20~25 years) ensuring that marginal costs are around 20$ per barrel.

Which means that conventional oil driller can absorb lower oil prices much better. BUT, THERE IS

A CATCH - Shale oil producers also have a secret weapon - they can quickly stop and start

production in short time cycles - when the demand is down, they shut production and when the

demand increases, they pump. Conventional drills have huge costs associated with stopping and

restarting drilling - making it very difficult to quickly react to demand changes (explains 'market

in-elasticity' of supply)

SO, WHATS THE BIG GAME?

Saudi Arabia V/s Shale Oil Companies: Saudi is playing to kill the US enterprises by inflicting

wounds on itself. Saudi assumes that because marginal costs of Shale companies are ~60$ per

barrel, if oil prices are lower than these levels for long enough time, Saudi can drive these

companies to bankruptcy. So a country with 20$ per barrel marginal cost is trying to kill

competition from companies with a nascent technology & strong management expertise. On the

surface atleast, this seems to be working - Shale oil companies have incurred losses, cut jobs,

dismantled some rigs and cut down investment overlays.

In first iteration, when fracking was found to be commercially viable, Shale oil companies went

into an overdrive and inefficiently bought lands, setup rigs and started digging. They have raised

huge equity and debt capital when oil prices were >$100 per barrel and didn't really care about

efficiency. But now they are compelled to cut down costs because they can't control prices.

Saudi is forcing them to be more and more efficient & this monster (efficient, lean and ruthless

corporations) is going to devour Saudi in the longer run, in my opinion. Nearsightedness may

deliver immediate results and it certainly seems to be the case but free markets will ensure that

corporations come out stronger from this onslaught & at some point, they are going to fire the

secret weapon in their arsenal. Loss making companies will go bankrupt and their assets will be

bought by bigger companies at cheaper prices, thus lowering overall costs over time. These big

companies will sit and wait for Saudi to make its move and when they do, they will quickly start

pumping oil and reduce the price quickly. In effect Saudi's pricing power will be neutralized

sooner than later.

This is a classic Prisoner's Dilemma - very quickly, Prisoner's Dilemma refers to two prisoners

kept in different rooms and asked to confess their joint-crime. If both don't confess, both will get

5 years of jail term. If one confesses and other doesn't, the person who confesses goes scot-free

while the other gets a lifer. If both confess, both will get a 20 year jail term. Incentives are

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stacked in such a way that the dominant strategy for both parties is to confess (called the ‘Nash

Equilibrium’). While both would have been better off had they remained silent, incentives force

them to adopt a particular behavior.

Party ‘A’ (Saudi) is punishing Party ‘B’ (US corporations) by adopting a dominant strategy. Sheikhs

have won this round but the only problem is that this is not a 1-round game. The next round

happens when Saudi tries to raise prices by cutting down production. At that time US

Corporations will punish Sheikhs by improving their efficiency & quickly pumping oil into the

market. This forces Saudi to continue to pump more oil at lower prices thus leading to persistent

low revenues. So Party B has adopted a 'tit-for-tat' strategy by punishing Party A for a last round

of punishment unleashed by Party A. If present value of future losses of Party A exceed the

immediate gains, Party A will finally fall in line and start co-operating. Eventually there will come

a time when Party A and Party B realize that it is useless to fight and bleed each other. At this

point, I believe oil prices will raise and the new technology (fracking) will make peace with old

technology (conventional) and we will begin to see price stability.

Saudi Arabia V/s Russia:

Simultaneously, Saudi seems to say that it will cut down production if Russia cuts down its

production. What is the logic here ? This story seems to involve Syria, terrorism, Iran, macho-ism

of Prince Salman and all the other geopolitical issues that are beyond my logical comprehension.

I will not venture making logical guesses in things I don't fully understand.

Saudi Arabia V/s Rest of OPEC

There seems to be another version of 'Prisoners dilemma' situation within OPEC. Protagonists in

this game are Saudi on one-side and poorer OPEC nations led by Venezuela on the other.

Venezuela has openly said that sustaining oversupply is not a viable long term strategy - there

seems to be a brewing mutiny here.

To see why Rest of OPEC is angry, check out this data of exports as a % of GDP and also

petroleum exports as a % of total exports. Check out the countries highlighted - and you get a

sense of why they are angry. Countries that are unhappy are completely dependent on

petroleum-based exports.

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Again in this round, Party A (Saudi) is inflicting pain on Party B (Rest of OPEC) [ Saudi itself is

absorbing pain but on relative scale, pain for poorer countries is much higher]. Inflicting pain on

yourself (OPEC countries) to inflict greater pain on others (Shale) is not a good long term

strategy, more so, for countries with lesser staying power than the bully in the room (Saudi).

Party B (OPEC countries) is losing this round but in the next round, when their patience runs

out, they will not co-operate, threatening to break down the unity of OPEC. This will cause

maximum damage to Saudi because it crushes their global control on oil prices. Again, future

pain would become so high that it more than offsets the current perceived benefit of keeping

prices low. At this time, Saudi will try to pacify its OPEC associates by cutting down production &

increasing price.

My Prediction

So, I stick out my neck to make a prediction (for what its worth) - Oil prices might fall further to

20$ (in the next 6 months) until Saudi realizes the foolishness of this strategy (compounded by

pressure from rest of OPEC nations) and slowly starts to cooperate with other stake holders. This

will lead to increase in oil prices (maybe around 60-70$) and reduce the long term volatility

around this price.

.