The Case For Crude Oil: Are US Shale Producers Getting in The Way of OPEC?

OPEC nations first agreed on production cuts of crude oil in an OPEC conference in November 2016 and further extended their cuts in May 2017. This was a response to the tremendous drop in West Texas Intermediate oil prices from $110 to $45 per barrel in 2014 due to a massive global oversupply. Thus far, their cuts have been successful with WTI crude oil prices reaching highs of around $66 and Brent crude oil reaching around $70 in 2018. However, according to EIA, US oil production has significantly increased in response to higher oil prices and hit all-time highs of 10.28 million barrels per day at the end of February, thus causing some downward pressure on oil prices. Will US’s increasing production of crude oil lead to drop in prices or can OPEC cuts keep them up?

As of February 2018, the compliance of OPEC member nations to the cuts were at a high of 149%1. Most OPEC members have been fairly compliant with the cuts, although it should be noted that a majority of this high compliance rate can be attributed to Venezuela ‘s inability to produce crude oil due to geopolitical tensions and to the shutdown of one of Libya’s oil pipelines. Moreover, Russia, a major global producer has also agreed to cut back on production along with OPEC member states as they too have an incentive to prop up oil prices. There is also speculation that OPEC could decide to extend the cuts into 2019 as the current deal may not be enough to ‘rebalance the market’, although there have not been any official discussions yet. On the other hand, OPEC member nations are notorious for cheating and producing more than they are allowed to, so the effectiveness of these cuts are dependent on whether OPEC nations can sustain this level of compliance.

Saudi Arabia, the largest OPEC producer has the most to gain from a reduction of oil inventories due to their plans of an IPO for their state-owned petroleum company Saudi Aramco. This is a key step in Saudi Crown Prince Mohammed Bin Salman ‘s Vision 2030 initiative in which he wants the Saudi economy to become less dependent on oil for government revenue. Saudi oil minister, Khalid Al Falih was hoping to set the date for late 2018, however, there is speculation that the IPO may be postponed to later as it seems they are hoping for a $2 trillion valuation2. This would mean that WTI oil prices would need to stay above $60 on average to justify this valuation.

On the contrary, US shale producers have been ramping up their production thus taking advantage of the higher prices and cutting in to global market shares. The EIA monthly report forecasts US production to reach 11 million barrels per day before the end of 2018, which would interfere with OPEC’s plans to reduce the global glut of oil3. We’ve seen the effect of increased US production on oil prices over the last 2 months as we have had some big corrections (drops of roughly $2-3). I’d also like to add that the most recent CFTC Commitment of Traders net speculative position shows that WTI crude oil has net long positions of around 750,000 contracts, which gives us a ratio of roughly 11:1 for longs to shorts4. This is the largest net long position that we have had in history, which puts prices in a vulnerable position.  When these large long positions eventually unwind, we will see a huge snowball effect of buyers liquidating their positions, which makes crude oil susceptible to a nasty selloff. Although, it does seem that these prices are going to be supported by bigger players at least until the end of the OPEC cuts and after the Aramco IPO.

Alternatively, an increase in US shale may not have such adverse effects on prices. On a MacroVoices podcast, Art Berman, a geological consultant for the institutions in the energy sector, mentioned that an increase in shale production isn’t necessarily bearish on oil5. This is mainly since within the US there is very little demand by US refineries for shale oil as they aren’t capable of refining shale oil into gasoline or diesel. The production of non-tight oil, the type that US refineries need to produce gasoline and diesel, is actually forecasted to decrease over the next few years, while US refineries are still continuing to demand non-tight oil. This explains how for the past few months, we have been seeing huge draws of oil inventory from Cushing, Oklahoma (major trading hub for WTI crude oil) as there is growing demand from refineries within the US

So, what does the US do with all this shale they are drilling? In late 2015, the export ban on US crude oil was lifted when the Obama administration signed the Consolidated Appropriations Act. This is beneficial for US shale producers as they are now able to export the shale they produce to meet the increasing global demand for crude oil and to countries who are capable of refining shale. IEA forecasted that they could meet 80% of global demand growth by 20206. Due to this, we could argue that increased production may not necessarily be as threatening to oil prices as people may believe.

So where will crude oil go? For the next few months, we could see WTI crude oil supported above $60 per barrel. The increasing production of crude oil will be perceived as bearish by the markets, which will cause a downward drag in prices. This is likely to limit how high prices could go up, however, I doubt we would see WTI prices fall below $60-57. Moreover, if there is any downward pressure on prices either from a massive unwinding of oil positions or increased production, OPEC can always negotiate extending the cuts further into 2019 to help support high prices.