OPEC is currently in a difficult situation. How should it react to the oil glut that followed the emergence of shale oil technology? In our view, today’s situation is comparable to the oil glut in the 1980s. Back then OPEC unsuccessfully tried to support prices by curtailing supply with the result that core-OPEC members were sitting on vast amounts of idle capacity for nearly two decades. Thus, we view the recent production cuts as an attempt to speed up the drawdown of the global inventory overhang rather than a sign that OPEC has returned to a policy of balancing the market. If OPEC, going forward, truly allows market forces to play out without carrying a lot of spare capacity, unforeseen shortfalls could result in violent price swings.
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Trading oil has been challenging over the past few months. To be fair, it has been challenging for a while, but those trying to predict price movements based on fundamentals have had a particularly hard time recently. Rather than moving with improving fundamentals, the oil market has hung on every word from OPEC officials, which has sent oil prices on a rollercoaster ride. In the past two weeks, fundamentals continued to improve with U.S. oil inventories showing counter-seasonal draws, yet prices collapsed on May 25 after OPEC announced it would extend production cuts by nine months. The price action indicates that market participants were hoping for an even larger cut and were disappointed that the current cuts were merely extended, but the current curtailments have already had a profound impact on inventories (we saw and continue to see large counter-seasonal draws in high frequency data), which is what we suspect OPEC had intended.
OPEC is currently in a difficult situation. How should it react to the oil glut that followed the emergence of shale oil technology? In our view, OPEC’s options and its influence on oil prices are limited. To understand this, we must go back to the 1980s, which is the last time OPEC was faced with a technological step change that led to an oil glut from non-OPEC producers.
OPEC was founded in 1960 by Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela. The founding members were later joined by Qatar (1961), Indonesia (1962–2008; rejoined 2016), Libya (1962), United Arab Emirates (1967), Algeria (1969), Nigeria (1971), Ecuador (1973–1992; rejoined 2007), and Gabon (1975–1994; rejoined 2016). By 1973, OEPC had increased its production to about 30 million b/d, just over 50% of world production. Supported by Egypt and Syria, the Arab members of OPEC imposed an oil embargo against the United States and other countries that supported Israel during the Yom Kippur war in October 1973. OPEC output subsequently dropped by close to 4 million b/d, which was about 7% of global output. As a result, oil shortages occurred in the west and prices soared from USD3.29/bbl in 1973 to USD11.58/bbl in 1974, and prices remained high even after the oil embargo ended in March 1974. In 1979 oil prices moved sharply higher again to as high as USD40/bbl. In our view, the 1979 price increase must be attributed to several factors; the Iranian revolution and ensuing Iran-Iraq war certainly played their part, but general USD price inflation was rampant, reaching 20% per annum. Arguably, part of the reason why inflation was so high was because oil prices had previously risen on the back of the oil embargo, which trickled into general price inflation. But even without the tightness in oil fundamentals, USD inflation would have been high given the monetary environment of the time; however, the price inflation in oil was several magnitudes higher than broad price inflation, suggesting that the tightness in the oil market itself was the main reason for the sharp price increase in oil. Most importantly, this prolonged period of extremely high oil prices and the crippling effect the oil shortages had on western economies led to profound changes in oil and energy markets.
Impact on Demand
Western utilities began to rapidly phase out oil from the electricity sector, replacing it with gas-fired and nuclear power plants. Additionally, western countries – particularly the United States – tightened regulation in the transportation sector, resulting in the downsizing of car engines and lower consumption. U.S. oil consumption went from a peak of 18.4mb/d in 1979 to 15.3mb/d by 1983. It was not until 1997 that U.S. consumption returned to its previous high. Western European consumption dropped from 14.4mb/d in 1979 to 11.7mb/d in 1983 and never recovered to its previous high. Even Japanese oil consumption, despite the country’s period of extraordinary economic expansion in the 1980s, peaked at 5.5mb/d in 1979 and dropped to 4.4mb/d by 1983. It returned to its previous highs in 1994 as Japan never fully phased out oil from the power sector.
Impact on Supply
While the effects on the demand side – particularly the phase out of oil in the power sector – were primarily a one-off effect that peaked in 1983, the impact of high prices lasted much longer on supply. Incentivized by prolonged high prices, global oil majors began to explore previously untapped oil sources. In Europe, this lead to the oil industry in the North Sea; in North America, oil companies began producing in the Gulf of Mexico (GoM) and Alaska. Once the oil companies figured out how to tap these resources, they could no longer be stopped. At the time of the 1963 oil embargo, Western Europe produced just 67,000 b/d of oil. By 1979, this had increased to 2mb/d. It was already close to 4mb/d 10 years later, and it peaked at 6.5mb/d in 2000. Oil production was at 13.6mb/d by 1973 in North America, but the outlook wasn’t particularly good; high prices led to a sharp increase in investment in the GoM, not just in oil but also gas. Oil production increased to 15.3mb/d by 1985 before leveling off; however, without the massive investments in GoM and Alaska production, North American production would have declined sharply throughout the 1980s.
OPEC’s Reaction and the Impact on Spare Capacity
When OPEC curtailed output in 1973, its revenues soared dramatically. While output was down 7%, prices went up 400%, leaving OPEC members with much higher revenues – especially once prices tripled again in 1979. The initial reaction to the surge in supply and collapse in demand was to cut output again to support prices. This time, OPEC had to dramatically slash output to balance the market again. OPEC output dropped from 30mb/d in 1979 to 17mb/d in 1983; however, it did initially help prices stabilize. Brent averaged $31/bbl USD in 1979 and was still averaging $29/bbl USD in 1983. On paper, it looked like OEPC was still much better off compared to 10 years earlier as exports had been cut in half but prices were still up tenfold which meant that revenues were up 400% over 10 years. The problem was that although total OPEC export revenues were up 400% over 10 years, the U.S. dollar had substantially declined in value over that period. Measured in gold (which we believe is the best denominator to assess true price increases over time), oil export revenues had in fact only increased by 40%. What was worse is that OPEC, and what we call core OPEC (Saudi Arabia, UAE, Kuwait, and Qatar), was sitting on nearly 50% of idle production capacity. Core OPEC tried to support prices by continuously balancing the oil market for nearly two decades, but investment outside of OPEC remained strong due to elevated prices. Non-OPEC output kept going up, which resulted in continuous downward pressure on prices. OPEC would have had to further cut output to counter the impact, but most member states were simply no longer able to cut exports as the combination of stagnating output, declining prices, and further depreciation in the value of the U.S. dollar would result in gradually declining revenues. OPEC members began to feel the sting of sitting on all this spare capacity as these declining revenues were concurrent with ever-increasing public spending in most OPEC nations. Non-core OPEC began to bring back production, which forced core OPEC members to leave even more production idle. As much as OPEC – especially core OPEC – tried to stem against the tide, prices eventually dropped to close to USD10/bbl by 1998.
What Did OPEC Learn from Two Decades of Expensive Spare Capacity?
What OPEC learned is that they simply lose market share if they try to support prices by cutting supplies – if they sit on spare capacity for decades, eventually prices will go where they would have in a free market anyway – so when it started becoming obvious that shale oil technology had the potential to lead a massive resurgence in U.S. (and potentially global) oil production, core OPEC members changed their tactic. Despite repeated calls from non-core OPEC members to cut output and support prices, Saudi Arabia, Kuwait, Qatar and the UAE began to increase production when spot oil prices started to tank in 2014. In fact, these countries had been increasing output long before the 2014 peak in oil spot prices, which impacted longer-dated prices beginning in 2011. To ensure that oil producers knew what they were up to, Saudi officials repeatedly stated that they felt market forces – i.e. prices – would eventually lead to a balanced market. At the outset, the market was not convinced that OEPC would just stand by and let prices collapse.
After all, when prices crashed on the back of the global credit crisis in 2008, OPEC stepped in and aggressively slashed output. To the surprise of the market, compliance among OPEC members was exceptionally good, but OPEC faced a different problem in 2008-2009. Supply wasn’t the issue. Despite a 10-year period of relentlessly rising prices, the oil industry hadn’t managed to tap new resources in a meaningful way. Oil majors kept pushing the boundaries of what was possible in the conventional oil space, going from drilling in shallow water GoM to ultra-deepwater projects (technologically highly impressive but also very expensive), Canadian oil sands (technologically less impressive but even more expensive), and politically very unstable regions (ultimately the most expensive sources), but they didn’t find a technological solution that would change the trend. Non-OPEC production was growing, but it was more a trickling than a flood and the outlook for future supply was dire and thus the reason for the oil price crash in 2008-2009 was that global demand had collapsed; by cutting supply, OPEC balanced the market without the risk of allowing an incumbent technology to take their market share. Once demand began to recover, OPEC supply quickly returned to the market.
In contrast, things permanently changed with shale oil. By 2011 the technology had already completely revamped the U.S. natural gas market and began to do the same in oil. Despite billions of investments in increasingly complex projects in the GoM, U.S. production was roughly flat between 2000 and 2010. Production then grew by 0.3mb/d year-over-year in 2011; one year later, it grew by 1mb/d y-o-y. In 2014, U.S. shale output grew by a whopping 1.7mb/d y-o-y even as prices crashed by 50% by year end. In contrast, global demand growth is around 1.1-1.5% with global GDP growth at 3%. It became obvious that shale oil technology scaled extremely well and OPEC faced a difficult choice. They could reduce output to stem the rapid decline in prices, but that would simply mean losing market share to shale oil in the long run, so they decided to let the market play.
Core OPEC producers have extremely low production costs and economically have no problem competing with shale oil producers, but core OPEC producers had become dependent on higher prices to support their massive public spending. Core OPEC producers could weather lower prices for quite some time, but the hope was that a lot of shale oil producers would eventually be pushed out of the market because of the low prices. Whatever the price would be once the market balanced is what they had to live with.
That strategy seemed to work at the outset; oil prices dropped to USD45/bbl USD by early 2015, but gradually began to recover and reached USD60/bbl by mid-2015. It seemed like OPEC’s strategy had succeeded and USD60/bbl was the new USD100/bbl, but the initial recovery was inconsistent with fundamentals. Underlying fundamentals continued to deteriorate and inventories made new highs monthly. As a result, oil prices began to decline again in 2H2015 and dropped to USD27/bbl in early 2016. Prices recovered, but have having difficulties remaining over USD50/bbl for a sustained period. With prices over USD50/bbl, drilling activity in the U.S. shale sector began to pick up. Initially the sharp sell-off turned production growth into production declines again. U.S. output was down 0.5mb/d in 2016, but production began to sharply accelerate again over the past few months, and U.S. output was up 0.5mb/d year-over-year and accelerating as of May.
In November 2016, OPEC announced it would curtail production to 32.5mb/d – an implied cut of about 1.3mb/d from actual output. The implementation of the quota was scheduled for January 2017, but it took longer to achieve full compliance. Libya and Nigeria initially produced below quota and continued to do so for some time due to ongoing security problems, but both countries eventually began to sharply increase their output (and continue to do so). Oil prices initially rallied on the announcement of the curtailments, and from a fundamental perspective, it worked. Global oil Inventories had already plateaued and were about to tip over and decline, and the output curtailment greatly accelerated the process (we have written about this several times in our assessment of weekly petroleum statistics provided by the U.S. department of energy (read our comments on the weekly DOE oil charts here); however, after oil prices recovered from USD45/bbl to more than USD53/bbl, prices started to decline.
Despite the fact that the inventory situation is rapidly improving, last week’s OPEC decision to extend the production cuts for nine months was met by a renewed sell-off. It seems that the market had priced in even further curtailments – but to what extent does the market think OPEC will cut supplies over the long run?
OPEC is once again at a crossroads. Should it try to support prices by balancing supply with demand or leave it to the market? OPEC learned that the price recovery over the past few months already led to a strong resurgence in U.S. production. U.S. rig count has been increasing since June 2016, and given the lag in rigs being deployed until oil is coming out of the ground, we will likely see a further acceleration in production growth. If OPEC managed to push prices sharply higher with more production cuts, rigs would be redeployed even faster, and US production growth would accelerate further a few months down the line.
In our view, the best OPEC can hope to achieve is an acceleration of inventory drawdown over the coming months. The November cut seems to accomplish this, which is why we have been bullish on time spreads, but beyond that OPEC is facing the same dilemma as it did in the 1980s. Any attempt to push prices meaningfully higher will only be met by shale oil stealing market share, and OPEC members will ultimately sit on more spare capacity.
There is one difference between what’s happening now and what happened in the 1980s: back then, OPEC spare capacity provided a large buffer for unforeseen events. Pretty much any production shortfall – other than Saudi Arabia itself – could have been offset by bringing back spare capacity. As a result, oil prices experienced very low volatility for a period of about 15 years. Many market participants, including some prominent OPEC members, believe this spare capacity is no longer needed as shale oil can be brought on very quickly. The role of balancing the market would fall on shale oil producers rather than OPEC; however, while shale oil production is very flexible, it would still take several months to considerably ramp up supply. To mitigate this risk, inventories could permanently remain at higher levels. The problem with that is somebody has to pay to store those inventories which would require a permanent Contango, at least in the front of the curve. This would be a fundamentally different situation to the 1980s, as it almost always traded in backwardation.
However, if inventories are allowed to normalize and OEPC continues to keep minimal spare capacity, which seems the reasonable (economically) thing to do, this would create entirely new risk. Small fluctuations in supply and demand could be met by ramping up or down shale oil supply, but an unforeseen shortfall of a major producer would potentially push oil prices sharply higher, in true 1970s fashion.
WHAT IS INFLATION?
The original definition of inflation is an increase in the amount of money in circulation. Today the term inflation is mostly used to refer to the rate at which the price level, however defined, is rising. For example, a good that costs $100 today and $110 a year later experienced inflation of 10%. When referring to the original meaning, economists therefore often use the term ‘monetary inflation’ to distinguish from ‘price inflation’. Economists create weighted baskets of goods and services to estimate overall consumer price inflation. For example, the consumer price index (CPI) reflects the price development of a basket of goods and services that aims at replicating the typical consumer’s cost of living.
WHAT IS THE CURRENT INFLATION RATE?
There is no straightforward answer for this. Price inflation can be estimated in many different ways. The two most widely accepted price inflation indices are PCE (personal consumption expenditure) and CPI (consumer price index). The former is used by the Federal Reserve when setting US monetary policy and the latter applies to cost of living adjustments for US Social Security and certain other federal government benefits. We find that CPI inflation expectations have been a key driver for gold prices. CPI inflation also usually tends to be higher than PCE inflation. CPI (urban consumers) inflation in February 2017 came in at 2.7% year-over-year which is a sharp pick-up from just 1% half a year ago.
WHAT IS THE NOMINAL INTEREST RATE?
Nominal interest rates are simply the interest paid on an investment in percentage terms. For example, a bond that sold for $100 and pays a $2 coupon per annum has a 2% interest rate. However, the value of a bond deviates from its face value over time when overall interest rates change. When interest rates decline, (all else equal) the bond above would increase in value as it now pays a higher interest than bonds that are issued today. Therefore, in financial markets one would usually refer to the yield of a bond—which is simply the return on the bond(coupon / price)—for comparison purposes. If the bond is trading at par (price is the same as the face value), the interest rate and the yield are the same. What makes things more complicated is that the two terms are often used interchangeably. In that case, the term interest rate is usually used to describe the yield of a fixed income instrument. Most people are not active investors in bonds (although they might be via their pension funds) and know interest rates only from their bank account. The interest paid on a savings account is equivalent to its yield and is a nominal interest rate.
WHAT IS THE REAL INTEREST RATE?
In contrast to nominal interest rates, real interest rates also take the level of price inflation into account. Broadly speaking, real interest rates = nominal interest rates + price inflation. Hence real interest rates measure the return on an investment in actual purchasing power. Why do real interest rates matter? For example, when interest rates are at 5% p.a. but inflation is 10% p.a. , after one year the lender has earned 5% in nominal terms, but he actually has lost value. More specifically, with an initial investment of $100 he would end up with $105 after one year. But those $105 would only buy him 95% of the goods and services the original $100 bought a year ago. Thus when price inflation is higher than the nominal interest rate on savings accounts, savers are de facto paying to lend out their money to the bank. Currently the national average money market account rate is 0.27% while inflation is 2.7%, hence savers lose 2.4% of their purchasing power per year if price inflation stays at this levels.
WHAT IS THE FED?
The Fed is short for the US Federal Reserve, which was established in 1913 by the US Congress. The Fed is headed by the Board of Governors of the Federal Reserve, consisting of 7 presidential appointees serving 14 year terms. It’s most important body however is the Federal Open Market Committee (FOMC). The Current chairwoman of the Fed and FOMC is Janet Yellen.
The Fed has several functions. It acts as the lender of last resort to financial institutions that temporarily lose access to the capital markets in a crisis. It exerts other banking functions such clearing the transfer of funds from one bank to another. It also acts as the US government’s bank and sells and redeems government securities. However, what receives the most attention is that the Fed determines monetary policy, that is, the level of nominal interest rates. The monetary policy decisions of the Fed, such as setting interest rates, are made by the FOMC.
WHAT IS THE FOMC?
There are 12 voting members of the FOMC: the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York and the presidents of four other regional Reserve Banks (on a one-year rotating basis). There are eight scheduled FOMC meetings per year. When the FOMC sets interest rates, it actually sets the lower and upper bounds of the federal funds rate, the rate at which banks either lend out or borrow reserves in order to meet statutory reserve requirements.
WHAT IS THE FEDERAL FUNDS RATE?
The federal funds rate is the overnight interest rate at which a depository institution (a bank) lends funds to another depository institution. The Fed only sets a target band; the banks can in theory charge each other what they want. However, in practice the rate at which banks lend to each other is always within this band. The Fed uses open market operations to ensure that the fed funds rate stays within the target band. This means that it buys and sells securities (normally US Treasuries) from its member banks and replaces them with Federal Reserve credit. The upper band is called the discount rate. Even though the Fed prefers that banks to borrow from each other, the fed funds rate should in theory not be able to exceed the discount rate as otherwise the banks may simply borrow directly from the Fed itself. What makes the fed funds rate so important is that it necessarily influences all other interest rates as well. Hence by setting the fed funds rate target, the Fed is able to influence credit conditions throughout the economy.
WHAT IS FORWARD GUIDANCE?
At the end of an FOMC meeting, the Fed announces its outcome and releases a statement that aims to provide the public with information about the FOMC members’ views in regards to current macroeconomic conditions as well as their expectations thereof. Among other data, the Fed publishes a so called dotplot which shows where the FOMC members believe the Fed funds rate will be at the end of each year for the next few years and over the long run. The median projection is regarded as the Feds forward guidance for the interest rate path. Often the market is more interested in the Feds forward guidance than in the most recent monetary policy decision itself. For example, when the Fed announced its third rate hike in 11 years on March 15, 2017, the market reaction implied that the Fed had become more dovish rather than hawkish. The reason for this was that the Fed left its interest rate projections largely unchanged while the marked had expected the adoption of a more hawkish outlook.
WILL THE FED RAISE INTEREST RATES?
At the moment it seems likely that the Fed will continue to raise rates. Since the Fed began to depart from zero interest rates in December 2015 it has raised rates three times by 25bps (0.25%) each. According to the Fed’s own dotplot forecasts the Fed is anticipating raising rates to 3% by the end of 2019. However, the market is not expecting the Fed to be able to raise rates as quickly as the Fed’s forward guidance suggests.
WILL REAL INTEREST RATES RISE?
Unlikely. We believe the Fed will only continue to raise nominal interest rates as long as the US economy keeps expanding and inflation remains above the 2% target. This suggests that at the end of the current hiking cycle, realized real interest rates will not exceed 1%. However, we are currently already in the second longest period of economic expansion in US history. Should the US economy slow down or even fall into recession, the Fed would more probably have to cut rates rather than raise rates, in our view. We would expect real-interest rates to go sharply lower in such a scenario.
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