As Oil Prices Plunge, What Will Swing Producers Do?

Crude oil has three swing producers -- North America, Saudi Arabia and Russia -- and two highly influential swing consumers (China and the United States).  Although events in a multitude of other countries can influence the market, how these swing producers and swing consumers interact goes a long way toward determining the outlook for oil prices. Moreover, the behavior of these actors explains to a great extent the recent crash in oil prices – the steepest downdraft since the 2014-16 bear market (Figure 2) -- and give some insight into what might happen next.

A swing supplier is one who can increase or decrease production to impact oil prices in a major way.  North America (US + Canada), Saudi Arabia and Russia can do this and each of them has its own set of motivations and constraints.

Of the three, North America is now the dominant swing supplier.  U.S. and Canadian suppliers differ from their Russian and Saudi counterparts in that their production is almost purely the product of a competitive marketplace whose suppliers are driven by the free market and with minimal state interference. The central importance of North American producers is easily seen in the global production numbers.  Since the end of 2005, global production excluding North America has grown by only 4.7%, or 0.35% annually.  Meanwhile, North American production has risen by 95%, or 5.3% annualized growth (Figure 3), driven by a 105% rise in the US and a 73% increase in Canada.

This isn’t to say that U.S. and Canadian production exclusively determine global prices.  Twice so far this decade, the interaction of North American producers, the Saudis and geopolitical events have allowed oil prices to stay far above what fundamental models would have suggested for extended periods of time (2011-2014, 2017 and 2018).  In both cases, these periods were followed by abrupt price corrections.

The first period in which oil prices ignored growing North American production occurred during the three and half years after the beginning of the Arab Spring.  Between April 2011, when protests began to shake the foundations of Egypt, Libya, Syria, Tunisia and Yemen, and October 2014, North American production grew from 16.4 million to 22 million barrels per day of crude and other liquids.  Oil prices levitated between $80 and $115 per barrel. There were a number of reasons for the lack of negative price response to the growing North American production.  First, there was a sharp drop off in production from Libya, whose production fell from 1.8 million to 0.5 million barrels per day and a similar, but less consequential, drop in Syria, whose crude oil output fell from 416,000 barrels per day to 29,000.  Small amounts of oil came off the market from Tunisia and Yemen as well.  These declines offset about one-third of North America’s production gains.

Second, there was a fear that the violence and unrest in these countries might spread across the region to Iran, Iraq and the Gulf States.  This never happened but it, along with growing tensions over Iran’s nuclear program, contributed to fears of regional instability and kept oil prices elevated with the oil maturity curve in severe backwardation, suggesting the existence of a substantial fear premium in the spot market.

Lastly, there was the boom in emerging market demand which was led by China. We’ll discuss this further in a follow up article on the “swing consumers” of oil^.1

In the fall of 2014, high oil prices were on a collision course with soaring North American output amid a reduction in global tensions and growing concern in Saudi Arabia about losing market share to American shale oil producers. It had become obvious that the Gulf States had successfully insulated themselves from the chaos of the “Arab Spring.”  Moreover, Iran and Iraq were increasing production.  Finally, the US, UK, France, Germany, Russia and China were making progress towards the Iran Nuclear Deal (officially known as the Joint Comprehensive Plan of Action or JCPOA).  All of this put oil prices on a bearish tilt.

In November 2014, OPEC members, such as Venezuela, requested that the Saudis step in and cut production.  Instead, the Saudis decided to try an experiment.  Rather than swinging to a lower level of production to maintain prices, they continued pumping and let the price of oil crash in the hopes of maintaining market share in the face of rising U.S. production.  It didn’t work out quite as planned.

While the Saudis certainty expected oil prices to fall to or below the cost of production, they were probably surprised to see them go all the way to $26 per barrel by February 2016.  What’s more is that they were probably disappointed by the tenacity of North American producers.  While many suffered financial losses and cut back on investments and staffing, they also were able to lower the marginal cost of production from around $60 to around $40 per barrel. U.S. production declined from 9.6 million to 8.4 million barrels per day but, as soon as prices hit $40 per barrel, investment started picking up and by October 2016 production began to rise as well.  Even with oil prices still in the $50-$80 range – well below the 2011-14 range of $80-$115—U.S. production surged again to hit 11.7 million barrels per day by November 2018 (Figure 4).

Since oil hit bottom, the Saudis and the Russians have taken a different approach.  The Saudis corralled members of the Organization of Petroleum Exporting Countries (OPEC) into limiting production starting in 2016. And surprisingly, OPEC has largely stuck to its agreement with relatively minimal breaches.  What’s more is that Russia, for the first time, joined with OPEC in limiting production.  So far, this decision has been marginally successful, supporting oil prices above $45 per barrel since they agreed to the cuts, but not able to keep oil prices in the $60 to $70/barrel territory for which they were hoping.  The problem is that the higher prices incentivized an enormous increase in U.S. production.

Closely following the OPEC production cuts, a new Administration arrived in Washington and quickly set about pulling out of JCPOA or the Iran Nuclear Deal.  By the time of the widely anticipated U.S. departure from JCPOA, oil prices were over $60 per barrel and on their way to the $70-$80 range as the US threatened the imposition of new sanctions on Iran.

The U.S. decision to pull out of JCPOA split the international community.  Israel, Saudi Arabia, Egypt, the UAE, Bahrain and Yemen’s official government supported the decision.  Most other countries, including the signatories to the agreement (China, France, Germany, Russia, UK and Iran) opposed the U.S. decision to leave, as did Turkey and Jordan. Of the supporters of the U.S. decision, Saudi Arabia was the lynchpin in terms of providing regional leadership to back the U.S. move and to help enforce sanctions on Iran.

It’s curious then that oil prices peaked on October 3rd, the day after Saudi journalist Jamal Khashoggi walked into the Saudi consulate in Istanbul never to be seen again.  The Khashoggi incident put the Saudi government on its heels as Turkey slow walked the release of damaging information, keeping the story in the headlines now for well over a month.  Traders appear to construe that anything which damages Saudi Arabia’s ability to help limit Iran’s oil production and sales as being bearish for oil prices.

Also, in October 2018, there were warning signs that the US might not be as tough on Iran as was initially perceived by market participants.  Indeed, on November 5^th, the US announced temporary exemptions from Iran sanctions for eight countries, including big oil buyers such as China and India, thus effectively giving an extra downward push to oil prices.  Once again, an apparent reduction in tensions has caused the air to rush out of a risk premium on oil and allowed the economic reality of soaring North American production to seep back in.

In the short term, U.S. production will probably continue to climb.  It appears to follow prices with approximately a six-month lag.  As such, the recent slump in oil prices might not negatively impact U.S. production until as late as spring 2019, by which time production may top 12 million barrels per day.

U.S. fracking plays, however, have steep increases in production and equally steep falls.  So far, in aggregate, increases in supply from new fracking plays have exceeded declines from plays that are past their peak.  That said, one cannot rule out steep fallbacks in U.S. production in coming years, particularly if prices were to fall further and remain relatively low, by which we mean below $50/barrel, for an extended period.

Saudi Arabia, meanwhile, faces a very different set of issues.  While the Khashoggi incident doesn’t appear to have loosened Crown Prince Mohammed bin Salman’s (MBS) grip on power, the Saudi government faces a host of issues, which include:

• The war in Yemen, which is the subject of growing international backlash.
• Cutting off diplomatic relations with Qatar, which has become increasingly close to Saudi Arabia’s arch-rival, Iran.
• The Aramco IPO has been shelved amid a lack of investor appetite.
• The recent 30% decline in oil prices will tighten budgets.

For the moment, options traders aren’t pricing much in the way of upside risks with oil options skewed sharply to the downside (Figure 5).

Meanwhile, Russia rarely uses its clout in the oil markets to influence prices unless it agrees to coordinate with OPEC.  Russia and the other members of the Former Soviet Union did, inadvertently, act as swing producers during the 1990s when production tumbled in the wake of the Soviet Union’s collapse.  Since Putin’s rise to power, Russia has largely been a price taker in the oil markets, reluctant to use its clout to influence prices – something that it has not shied away from in the natural gas market.

Russia’s influence might grow, however, in the future.  Russian production has been stable, and its reserves remain enormous. Moreover, it hasn’t widely applied more modern and efficient technologies.    Hence, there is considerable room for Russia to expand production over the next decade making it highly likely that Russia will continue to be one of the world’s dominant oil suppliers.

• Options traders remain focused on downside risks following a 30% slide in WTI.
• U.S. production could continue to rise despite the recent slide in prices.
• The shale production boom could go into reverse in the future if oil prices drop below $50/barrel and remain there for an extended period of time.
• Saudi Arabia faces significant domestic and international challenges that could hold upside surprises for oil prices, but for now Saudi Arabia is perceived to be deeply indebted to the US
• Russia has been reluctant to play the role of price setter in the markets but that could change in the future given the long-term prospects of Russia’s increasingly important role in global oil production.

1. See: “Four Ideas to Consider when Analyzing Long-Term Prospects for Oil and Natural Gas” by Blu Putnam in the Fall 2018 issue of Global Commodity Applied Research Digest (GCARD), published by the JPMorgan Center for Commodities, http://www.jpmcc-gcard.com/.