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Watching those oil slides

Thursday, March 16 2017

Oil prices, which have been trading in a narrow range, fell by 8% last week Wednesday. This certainly was the worse one day drop in the price of oil in about a year. WTI and Brent dipped below US$50 and US$53 respectively and are at levels not seen since OPEC announced its deal in December. The decline could be traced to a combination of increasing US oil production as well as a significant rise of 8.2 million barrels of crude oil inventories, which resulted in total stocks approaching record high levels.

Against this backdrop, OPEC tried to engage shale producers in dialogue. During the CERAWeek Conference in Houston, despite openly trying to drive oil prices down and inflict mortal wounds on the shale producers, OPEC officials attempted to address their differences with Shale producers to cut down on market volatility. It is reported that OPEC’s Secretary- General had meetings with shale executives, and met with investment banks to better understand OPEC actions on the market. One can only wonder if any consensus was arrived at between these previously warring competitors.

In an obvious effort to exert some market discipline the Saudi energy minister Khalid al-Falih issued a warning to shale companies that they should think carefully and not move too quickly. Again, one has to wonder what the thinking is since shale producers could begin production from within nine days of a full shut down. What does “move too quickly” mean in this context? Of course, the argument presented is that OPEC would not bail out the shale industry if it makes unjustifiable investments. A shale executive told Reuters that Khalid al-Falih said “we and other shale producers should not automatically assume OPEC will extend the cuts”. The statement is so relevant given the fall in oil prices that are set against fears of oversupply.

Such developments have placed considerable weight as well as speculation on OPEC’s production cuts. There is the question whether the cartel will consider extending their deal through the end of 2017. To this, OPEC officials responded that they would delay any action until May when an examination of US inventory levels will be undertaken and then the appropriate response will be adopted.

However, oil prices are already falling; if there is no extension of the cuts this will imply losses soon. Analyst such as Tamas Varga at London-based PVM brokerage have argued that “If OPEC doesn’t extend the deal, that would be price suicide, plain and simple”.

We need to assess the ability of OPEC’s members to ensure compliance with the deal in which OPEC and 11 non-members in December 2016 decided to trim supply by as much as 1.8 million barrels a day. OPEC’s total output remains 550,000 barrels a day above the target set out in the November 30 deal. That means the group as a whole is only about 60 percent of the way toward the production level it deems necessary to eliminate a global oversupply and boost prices.

Certainly, our readers would have heard about the role of speculators and the effects of their actions on oil prices and the oil market. As returns on investment fell globally, commodities proved to be a great avenue to improve on the rate of return investors received, at least those who were willing to take the risks. One thing is certain - there are several speculators who have made large investments in crude oil. This includes both hedge funds and institutional investors. Such record positions are under review and it is expected that that the changes that have taken place in market sentiments would lead to these so called speculators looking to get out of the oil market.

There are those who think that the speed at which these speculators leave the oil market could determine the nature of the price changes that will take place. John Kilduff, founding partner at hedge fund Again Capital, suggested that a steep decline in the price of oil could see oil fall to $42 per barrel by the end of April. The liquidation of their positions ends a rally which began possibly in October and/ or November 2016 and ended on February 1, 2017.

Going forward we need to monitor the actions of speculators on the international price of crude oil as well as gas. The rapid unwinding of their positions could have a serious dampening effect on oil prices. This will effect government’s revenues, foreign exchange earnings, and business sentiment.

More importantly the anticipated recovery in the energy sector was predicated, not only on an increase in gas production from new fields, but also some firming up of prices tending toward US$60 a barrel. The end of the 100 percent write-off in capital investment in the first year, while welcomed, will be inadequate to counter a dramatic fall in oil and gas prices. Such a possibility we have to plan for.

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