Wikipedia defines stress as “a physical quantity that expresses internal forces that neighbouring particles of a continuous material exert on each other. When a liquid is in a closed container under pressure, each particle gets used against by all the surrounding particles.” This theory best describes the current dilemma of all OPEC producers and the “stress” experienced by them as oil threatens $40/barrel.
Is it irony or just mere coincidence that every time oil touches $40/barrel, “OPEC cuts” and “production freeze” headlines flood the tape? The frequency over the last few days implies we might be reaching the pain threshold once more. The cries were loud and rampant back in January as oil briefly touched $27/barrel, only to disappear when it rallied all the way up to $51/barrel. Today as oil flirts with the $40 price level, the corridors are filling up with whispers of cuts and emergency OPEC meetings once again. If these talks failed back in April, why would they be any different this time around?
In June OPEC output jumped to 10.67 million barrels per day (mbpd), up 123,000 barrels from June, surpassing the previous record of 10.56 mbpd in June last year. The year started with unusually high unseasonal demand for gasoline but then fell in April. However at the lowest monthly print, gasoline consumption was still up 74k bpd compared to 2015 and 2000 bpd below the record rate set in 2007; overall demand is up 2% year over year. There is just too much supply out there unable to compensate for the demand increase. Strong gasoline margins throughout the winter prompted refiners to run maximum gasoline yields in their refineries which resulted in quite a fast build up of excess gasoline in the system. Global oil demand growth in 1H was 1.9 mbpd. This was helped by China’s credit driven expansion together with unexpected supply outages seen in Canada and Nigeria. Now that all that has settled down and we are past peak summer driving season, could oil test its lower limit once again?
With US shale, Iran and Saudi Arabia pumping at maximum levels to gain market share, it is naive to think that these proposed cuts can save the oil market unless each and every producer is on board. Is that conceivable? Iran is currently exporting about 2 mbpd (close to pre-sanction levels) out of its daily production of 3.8 mbpd, hoping to maximise its revenues, or rather the lack thereof given the sanctions imposed on them over the last few years. Why would they cut production now?
The problem with oversupplied markets is that one has to let the price fall to a level where supply matches demand. For prices to rise sustainably, supply needs to permanently shut off rather than just switch off. Cuts may cause a temporary price squeeze only to cap prices later as excess capacity is stored. But then a junkie just looks for a quick fix and never thinks about the longer term implications.