Market analysis: Shale a sword of Damocles over oil

The Saudi energy minister, Khalid Al Falih, wants an inventory target for cuts. Hamad I Mohammed / Reuters

Opec and non-Opec members decided during their meeting on May 25 to renew their production agreement at current levels for another nine months.

In a joint statement Khalid Al Falih, the Saudi Arabian energy minister, and the Russian energy minister, Alexander Novak, stressed the need for an inventory target, rather than a price one. This decision, validating the million-barrel supply cut decided during the previous Opec gathering in November, was widely anticipated by market participants. It aims to reduce large commercial oil inventories that have reached a fresh high, 10 per cent above the five-year average.

So far, all signatories to the agreement have been very disciplined, the compliance rate to the current supply cut is close to 100 per cent, a very rare figure when compared with historic supply cuts. Saudi oil diplomacy has played a major role in initiating and maintaining this supply cut agreement. The market is almost balanced after three years of oversupply. In April, global oil supply reached 96.2 million barrels per day, almost the same level as in early 2015. On the other hand, demand is still expected to grow by more than 1.3 million bpd this year to reach 97.9 million bpd, meaning that inventories should start to reduce.

However, in this robust environment, oil prices have not rallied; Brent crude is still trading next to US$50 per barrel and has fluctuated in a narrow trading range in the past 12 months, between $43 and $52 per barrel.

The reason for this status-quo comes from the United States, the producer that has emerged as the troublemaker of the decade, with the development of the shale oil industry. This industry has benefited from a long period of oil price stability and low volatility between 2011 and 2014, not only to expand but also to generate strong productivity gains that have allowed US producers to reduce considerably their costs of production. US shale oil players have come a long way since they were sitting at the top of the cost curve. The recent recovery of oil prices, following the fall of 2014 and 2015, has allowed shale oil players to increase their capabilities and supply, sharing at the same time a good indication of their cost of production. The question is not anymore whether they can stay in business but how strong their supply growth recovery will be.

US oil supply has surged by 500,000 bpd since January 2017 and should increase more during the second half of the year because of vigorous drilling activity. The number of rigs in activity in North America has doubled since the lows of 2016 to reach 1,015 by the beginning of June, despite a shortage of equipment and crews, which has temporarily increased production costs. The profile of these shale producers, which are privately owned and economically driven in their decision to adjust their oil supply, offers a good predictability, but also constitutes a permanent threat to incumbent producers, thanks to their ability to adjust their production almost instantly to market prices.

Excluding major events that might create a disintegration of oil supply, future oil price appreciation is likely to be limited in time. Any additional rise in oil prices will bring back additional US competition to the game and Opec members and their allies will have no choice but to reduce their market share or to observe a new price drop. They have very limited options to counter them.

The resurgence of these US competitors is not a surprise, and they will act as a permanent cap on the market, not allowing oil prices to rise again to levels seen at the beginning of the decade, above $110 per barrel at their peak.

This new paradigm is a drain for many hydrocarbon-driven economies; their public budget revenues have already been halved in the past years. Their governments are still dealing with this transition, which looks set to continue for longer than expected.

Sebastien Henin is a managing director and the head of wealth management at Alienor Capital.

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