Oil market hopefuls were under the spell of magic happening at this past weekend’s Doha meeting of major global oil producers…It’s silly to think that any meeting and subsequent agreement between OPEC and non-OPEC producers will have any long-term impact on oil markets. Here’s why.
The oil market got out of whack because supply and demand got out of whack…and the only thing that will create market equilibrium is a rebalancing of supply and demand…anything artificial (such as a production freeze) will not work…if suppliers did decide to reduce production the price would likely rise in the short-term, which would encourage some producers to cheat and increase production.
In addition, higher prices would encourage the high-cost non-OPEC producers to crank up production…And guess what, that would lead to greater supply, which ultimately leads to lower prices. The only way to get to an equilibrium price is for the high-cost producers (some U.S. shale and conventional producers, North Sea, Mexico, Canadian Oil Sands, and Russia) to curtail production.
It hasn’t happened yet as producers are playing the equivalent of the game of “chicken” trying to hold on and squeeze whatever positive cashflow can be had from fields, while waiting for their competitors to drop out of the game.
Problem is, when everyone is thinking and doing the same thing, it takes longer for reason to prevail over hope. They aren’t earning enough to replenish depleting wells. So, eventually the cashflow from barrels starts to dry up, and the losers drop out, shrinking supply and bringing balance back to oil markets. Free markets work, but like many things in life, it can take longer than you’d think for the process to come full circle.
High cost producers today are pumping furiously to generate enough cash to stay alive. That’s all. It’s like the joke about the guy who jumps from a 20 story building. When he reaches the 5th floor he says “so far I’m fine”. The only things that matter are economics: long term costs and demand. Prices will be set based on these 2 things.
On a related note, how logical is it for oil producers (that means you Saudi Arabia) to drive prices down 70% to correct an oversupply of roughly 2%? These oil producers have given up 70% on prices to regain 2% of worldwide volume. Makes no sense. A better approach would have been to gradually increase supply, pushing prices down by perhaps 20%, which would have caused the highest-cost producers to reduce production, and the imbalance would have been rectified gradually over time. Instead, OPEC has overshot supply by a wide margin. The risks now are production declines so severe that we could see a price spike at some point in the future. And that doesn’t benefit the Saudis or other major producers, who are most interested in stable oil prices over the long-term, so that their customers have some predictability about prices, and don’t seek energy alternatives.