OIL PRICE WAR

Published On May 27, 2016
In Global, Automotive, ESG, Blog Archives

We all can feel it in our wallets after visiting the gas station: There is a raging oil price war. Thus, the black gold price has plummeted to its lowest possible level. Who are the opponents and who will win?

Let’s take a look back – the history of the US oil market…

In 1823, Samuel Brown patented the first industrial internal combustion engine, laying the foundation for a profitable oil industry. The first commercial oil well was discovered in 1859 in Pennsylvania by Edwin Drake, who was the first American to successfully drill for oil. In the following century, the exploitation of underground oil reserves accelerated quickly. During the 1950-60 period, crude oil had emerged as an essential commodity for Americans. As a result, the US tapped its major oil reserves located in West Texas (Bakken to Permian shale-oil basins) with the benchmark product called WTI (West Texas Intermediate). During the OPEC infighting in the eighties, new suppliers and futures exchanges emerged. Today, the international benchmark is Brent crude from the North Sea.

Oil supply glut – more and more oil in the market….

Since 2000 crude oil prices were rising sharply because of surging global oil demand. Particularly China’s demand used to outrun its supply. Consequently, the demand-supply mechanism led to oil prices reaching an all-time high of $147/barrel in 2008. Soon after, the supply caught up and the oil prices hovered around $100/barrel between 2011 and 2014. However, the supply increased even further, drastically inverting the price dynamic.

Since mid-2014, the world has been pumping out far more oil than anyone needs. This resulted in oil supply remaining much higher than the demand. The use of innovative hydraulic fracturing techniques to unlock vast quantities of oil from shale formations in the United States resulted in domestic oil production increasing from approximately 2 billion barrels in 2010 to around 3.4 billion barrels in 2015, capturing circa 10% market share.

On the flip side, OPEC (Organization of the Petroleum Exporting Countries) is also spreading more oil in the market to offset the lower prices with higher volume sales. The Opec controls more than 80% of the world’s crude oil reserves, which stood at 1,206 billion barrels at the end of 2013. Within the cartel, Saudi Arabia and Venezuela accounted for 22.1% and 24.9% of those reserves respectively. Iran has also sped up on producing much oil after its nuclear sanctions were lifted in January 2016. Putting all together, benchmark crude oil approached its seven-year low in December 2015 after OPEC opted to continue expanding its production levels. Brent was trading at $39.77/bbl with the WTI several dollars lower at $36.87/bbl. 

 2014 – The oil price war continues….

Over the past several years, the OPEC has been a giant on the world’s trading floors. Its 12 member nations were working together to determine prices by boosting or reducing their aggregated crude oil production. Of course, the OPEC generally favors higher oil prices to increase its members’ profit margins. However, facing low market prices, the OPEC failed to set drilling limits because its members tried to balance their finances with higher volume sales.

While the low oil price scenario remains positive news for consumption-led economies like US and Japan, it is a bane for countries like Russia and Venezuela. Russia’s economy is facing a potential meltdown and Venezuela is facing unrest and may default on its debt. At last, even better-prepared countries like Saudi Arabia could face headwinds from low oil prices.

The slump in oil prices triggered a heated debate among the oil majors (OPEC, US and non-OPEC like Russia). The latter are demanding reduced oil production from OPEC to collectively prop up prices in the market. Especially Venezuela and Russia urge the cartel to decrease its production because they need high oil prices in order to “break-even” on their government budgets.

On the other side, the biggest member of the cartel, Saudi Arabia – the world’s second largest oil producer – was opposed to denting oil production at its current level. Saudi Arabia is willing to let oil prices keep falling, because of its previous experiences. Saudi Arabia happened to cut its production levels in 1980 to support falling oil prices and prop them up. The result was that prices kept declining anyway and Saudi simply lost its market share.

Who will win the battle?

From all those consequences, OPEC is now engaged in a “price war” with the US and Russia. OPEC’s hope is that countries such as Saudi Arabia and Kuwait are keen to extract oil at a cheaper cost and pump more oil in the market in order to protect their market share amid the declining oil prices. Extracting oil from shale formations is far more expensive, which as a result would eventually make the business unprofitable for US competitors.

Conclusion

It is extremely difficult to predict who will win the battle. Talks have been held between OPEC and non-OPEC nation members very recently to cede oil production. However, Iran was ruled out from the last meeting and resumed production cuts until it complies with oil production at its pre-sanction levels. Furthermore. Saudi Arabia and Kuwait would like to freeze oil at the current levels despite their cutbacks. On the other side, the United States will continue to swell much oil every week or at least every month to add to its reserves.

For now, it is a wait-and-watch situation until the OPEC holds its next talk in June 2016; Will it be the end game or will it continue…? So far, many analysts are groping for oil prices. Until then it is extremely hard to predict the right prices and successors.

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Sham Kumar
Sham Kumar
About the Author

Sham Kumaris is an Equity Research Expert covering European equities, tracking Large, Mid and Small caps stocks. His sector expertise spans Automotive/Auto Ancillaries, Steel, Oil & Gas and the Consumer sector. He has a Bachelor's degree in Commerce and an MBA degree in Finance.

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