What You Can Expect from the “Oil Breakout”

Last night, I attended a very interesting closed-door energy meeting at the House of Lords here in London.

And as long-time readers will know, London’s financial district – “the City” – is the center of global energy capital. In fact, more money for oil and natural gas projects is raised within a three-mile radius of the Liverpool Street train station than anywhere else in the world.

Having spent a couple of days here, I can say without hesitation that one thing is clearly on the minds of every money kingpin in the City…

The current “breakout” in oil prices.

WTI (the New York crude benchmark) is up 53.4% for the year, and 19.1% so far this month alone, while Brent (the London equivalent) is up 34.5% for the year and 15.3% for the month.

Now, you might be wondering where this breakout is coming from, since oil supply hasn’t changed much since December.

But that’s not how markets work anymore. Today, perception is more important than reality.

And that perception is now changing – fast.

The Oil “Freeze” Deal is Moving Ahead

As of the close of oil trading yesterday, the world’s two primary oil benchmarks were both over $40 a barrel, at their highest levels in four months. WTI (West Texas Intermediate, the standard for crude futures contracts in New York) ended at $40.20 a barrel, its highest close since December 1 of last year. Dated Brent, the London equivalent, closed at $41.48 a barrel, its highest since December 4.

The immediate cause of this are the renewed international efforts to cap oil production.

As you saw on Wednesday, OPEC in general – and the Saudis in particular – need to get Iran on board to have any genuine chance to cap oil production. And remember, the Saudi-led refusal to cut production back in November 2014 was cast as an OPEC decision meant to force producers outside the cartel to sacrifice market share.

With Russia now apparently prepared to agree to cap production, Saudi Arabia can portray the oil “freeze” deal as a move that involves more than just OPEC countries.

A meeting is set for Doha (the capital of Qatar) for April 17. The Saudis and Russians have signaled they will agree to a production freeze using January figures. It now appears that Iran may agree – with a little help from OPEC…

“Petro-Politics” Makes for Strange Bedfellows

An important thing to remember about this deal is that January was one of the highest months for oil extraction in years. That means by agreeing to cap extractions at those levels producers really aren’t giving anything away.

This is to be a production “freeze,” after all, not an actual cut.

And as you’ve seen here in Oil & Energy Investor before, Iran is just coming off Western sanctions and obviously wants to secure a greater percentage of the global export pie to gain as much new revenue as possible.

Tehran has said that it would entertain a freeze only after essentially doubling its current exports. But adding some 2 million additional barrels to what is already an oversupplied world market is hardly conducive to supporting prices.

That’s where “petro-politics” comes in.

It’s no mystery that Saudi Arabia and Iran are adversaries. We see it in Yemen and Bahrain, in the storm whirling around Assad in Syria, and in the acrimonious Sunni-Shiite religious division that underlies it all.

Despite all of this, both sides understand that crude oil is the lifeblood of their economies, OPEC, and the region. As a result, an accommodation is in place whereby Iran is effectively allowed to overproduce, in return for Tehran providing cosmetic support for a “freeze.”

Now, “pundits” with no real experience in the oil industry, let alone an actual oil field, will claim that a production cap won’t have any effect at all, because supply will still be higher than demand.

Instead, some of them are saying that the cap may be a precursor to actual cuts in global production.

Good look with that one…

No Cut is Coming – but the Cap Will Work Anyway

There are zero indications among the major producers of any such intentions. That should come as no surprise, since one of the primary contributors to new international supply – American unconventional (shale and tight) oil – are not even at the table next month in Doha.

And U.S. producers have now been given permission by Congress to export oil after over four decades of being banned from doing so. It may take a while, but that new volume will be competing in some of the main markets already serviced by OPEC, Russia, and others.

No, the production cap is working, and it’s not because of some far-fetched notion that it will lead to a production cut. After all, in a perception-driven market, prices are not set by how much oil is traded, but about how that oil is traded…

Oil Prices are Stabilizing

As you’ve seen here in Oil & Energy Investor before, the trading of oil futures contracts and shorts (especially when the presumption was that the price would continue to drift downward) provided an “artificial” stimulus to declining prices.

Using the algorithm I designed to estimate the impact of this distortion, effective market prices for crude viewed by the actual end user of oil are actually $6 higher in New York (WTI) and $8 higher in London (Dated Brent) as of last Friday (the figures are crunched once a week). That put the actual value of WTI at $46.50 a barrel, and of Brent at $48.36 a barrel.

Given that my estimates remain at $45 a barrel for WTI and $50 a barrel for Brent by June, we are about there already. Even with the best of assumptions, we are hardly looking at prices moving to $60 a barrel or beyond anytime soon.

This means the significant recent rise in oil prices should end soon, and consolidate. Indeed, much of the current move up is simply investors covering their shorts.

This is also how the production “freeze,” even at the near-record production levels in January, is stabilizing oil prices.

The Cap is Changing Trader Expectations

You see, those who trade in the actual commodity (the “wet” barrels) rather than the futures contracts (the “paper” barrels) set their prices based on expected supply.

In a normal market, prices are set at the expected cost of the next available barrel. In a constricted market (where insufficient supply is an issue) they set the price at the cost of the most expensive next available barrel, to hedge against uncertainty.

But in the current climate, where the amount of supply coming into the market was expected to be increasing as producers fought each other for declining revenue, the opposite takes place. Over the past year, the assumption has been to set price based on the cost of the least expensive next available barrel.

The competition among exporters provided a way for traders to shave points from a contract and increase their profit margins.

A cap on production puts a ceiling on what traders can expect moving forward, and discourages pricing based on the least expensive next available barrel.

This will allow for some stability in price of oil moving forward.

Of course, demand is increasing and forward capital expenditures for expensive deep drilling projects in the U.S. and offshore have been dramatically reduced. This will lead to higher oil prices in the long run.

But at least short term, it will be the perception of traders, rather than the reality of the oil supply, that will support a restrained price breakout.

P.S. Marina and I are in London for the week, for yesterday’s meeting at the House of Lords, and for an Adele concert on Monday night (a gift for Marina). In the meantime, I’ve picked up on a lot of excitement in the energy markets here. Stay tuned for more.

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