Corporate Debt Review

Oil Realities and Pricing Pressure

$60-Handle Blues

Crude oil prices have been on a yo-yo for the past week.

At 2:30 PM on May 21, WTI (West Texas Intermediate, the benchmark crude rate set daily for futures contracts in New York) closed the trading session at $72.24 a barrel. It then proceeded to lose 8.9% through the close on June 1.

Meanwhile, the more widely used global standard and London-set Brent benchmark reached a closing high of $79.81 on May 23. By close on June 1, it had also declined by 3.8%.

Some of this was certainly to be expected, given a rapid earlier rise in crude prices. For example, WTI improved 7.2% for the month ending May 15, while Brent had shot up 9.6% for the same period.

However, the sound bites coming from pundits have largely missed the mark – either on the movement up or the subsequent retreat. This is not essentially about rising US extraction volumes or subtle signals from Saudi Arabia and Russia on maintaining production restrictions.

This is basically about the new balance that is rapidly forming in the international market.

That balance has been developing for some time. While it addresses traditional considerations of supply and demand, there have been some added wrinkles of late.

My analysis, buttressed by a decidedly strong opinion among my global contact network, is two-fold in nature. First, the slide is coming to an end. And second, the floor of the pricing band is moving up. Both point toward mid-$70 WTI and plus $80 Brent in the near term.

There are three overriding elements indicating positive directionality in crude oil pricing.

Back in Black

First, the net impact of increasing US production is skewed. Significant pipeline bottlenecks are forming as rapidly increasing Permian basin volume comes on line. That traditionally caps prices in the American domestic market as the surplus in storage weighs on bottom lines among operators.

In previous episodes, where the condition of storage at Cushing, OK (the location where daily WTI pricing levels are actually pegged) was responsible for downward pressure, the impact WTI had on the global market (where the effective crude price is actually determined) largely resulted from how much crude was imported into the US.

That has changed given the rapid increase in US exports. A few years ago, in an eleventh-hour Congressional budget accord, a four-decade prohibition on exporting oil produced in the US ended.

Domestic production will soon move past 11 million barrels a day, while daily exports are hitting almost 2.5 million barrels. The combination of these two factors had driven the angst among those convinced prices were about to tank.

Now some of this concern was wishful thinking by traders who know only how to make money from running short plays. But the reality has been moving in another direction. The ceiling in overall export capacity is being reached. Over the near-term, this means that access to higher-priced foreign markets is becoming more difficult for rising American extraction.

This will limit further appreciable increases in domestic production levels.

There is a bit more flexibility in the export of American oil products. US refineries are already leading the world in the export of processed products. But this now puts a premium on pipeline capacity in those networks leading into and out of refineries.

Nonetheless, the ability to balance domestic and foreign demand/price will put selected US refineries in a sweet spot for rising profits. On the other hand, the combination of rising storage volume and inability to pass through this volume completely to export will begin to limit the upside advantage of additional lifting.

What separates the current situation from the recent past is the condition of wellhead pricing – the actual proceeds received from a company’s first arms-length transfer of production when the oil comes out of the ground. While wellhead is lower than market price, these days just about all operators are running in the black.

There are fewer reasons to sell whatever they can as soon as they can. Companies are no longer racing just one step ahead of the sheriff.

It’s A Long Way To The Top (If You Wanna Sell Abroad)

Second, the global market is exhibiting a pronounced widening of the spread between Brent and WTI. As of the close on Friday, the difference between the higher Brent price and WTI stood at 14.3% of the WTI price (the more accurate way of measuring the genuine impact of the spread). This is a figure not witnessed since March of 2015.

Now both WTI and Brent are sweeter (less sulfur content) grades than over 70% of the global crude trade on any given day. That “sourer” oil is overwhelmingly traded at a discount to one or the other of the dominant benchmarks. And despite being of slightly lower quality than WTI, Brent has been the main yardstick of international transactions.

That combined with the periodic bottlenecks in the US delivery system, now once again augmented by additional volume coming online, has resulted in Brent carrying a market price higher than WTI for all but a few trading sessions since mid-August of 2010.

It also means Brent is more sensitive to geopolitical events than is WTI. This has especially been noticeable over the past several weeks as the global market has been rattled by three Trump-inspired shock waves: imposition of steel and aluminum tariffs, the ending of JCPOA (the Iranian nuclear deal), and a looming broader trade war with China.

All of these dynamics are likely to influence (and unsettle) oil prices.

Keep in mind as well that moves in both bunker and shipping fuels set to come online in about 18 months, combined with more pressing drives to offset advancing environmental problems in Asia, are cycling future oil trade away from higher sulfur grades.

Meanwhile, as both benchmarks have retreated from highs over the past eight trading sessions for WTI and six for Brent, Brent has been more tempered (and in line) with the changing international environment.

Walk All Over You

Third, and perhaps most importantly, are the geopolitical factors themselves. New US sanctions against Teheran will have some impact on reducing Iranian oil exports, although those pressures are still at least a quarter away and will face concerted opposition from all the other JCPOA parties (the UK, France, Germany, Russia, China, and the EU).

Nonetheless, assuming American action is forthcoming, it will somewhat lower overall volumes in the international market. The more concerted pressures on available supply, however, are coming from other sources.

Leading the list here remains the implosion underway in Venezuela. The national oil company PDVSA is facing a triple-whammy: effective defaulting on its bonds; a collapse in working capital to service expensive heavy oil deposits; and a central government budget spiraling into a fiscal meltdown.

My estimates put PDVSA at 1.3 million barrels a day by next month, less than half of what the level had been two decades ago; the steepest decline worldwide in the past three years. This has been worsened by a noticeable cut in American imports of Venezuelan oil, standing at just above 400,000 barrels a day. It had been north of 700,000 barely a year ago.

Added to these problems are the inability of PDVSA to maintain terminal contracts for exports via several main Caribbean ports, further intensifying the squeeze, along with the company’s loss of control over both production assets and export revenue proceeds to Russian and Chinese sources of credit.

Continuing problems in maintaining production levels in Libya, Nigeria, and even Mexico add to the leverage provided for absorbing additional volume from elsewhere while still allowing for higher market prices.

There were some rumblings last week that Russia and Saudi Arabia may depart from strict adherence to the production caps agreed to. The rumors had little credence from the outset, since my Russian, Saudi, Kuwaiti, and Emirati contacts roundly dismissed them.

At Brent prices well above $75 a barrel, there are profits to be made by maintaining the balance. Additionally, the Saudis need to raise the price further in advance of the historic Aramco IPO. That offer will have a share price dependent upon the underlying market value of Aramco extractable reserves. Moscow has a similar matter to consider as another secondary issuance in national oil company Rosneft seems under consideration.

Both require a rising price.

To these geopolitical factors are additional elements arising more directly from the increasing and more pervasive acrimony of international events. Here, three are paramount: Beijing moves in the South China Sea; rising tensions in the Persian Gulf; and the impending rupture of the G7 in the aftermath of US tariff decisions and its avowed departure from NAFTA and the TPP.

Such a cocktail usually results in pressures driving prices up. Uncertainty has a way of doing that.

About the Author

KentMoors

Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk management, emerging market economic development, and market risk assessment.

He serves as an advisor to the highest levels of 27 countries, including the U.S., Russian, Kazakh, Chinese, Iraqi, and Kurdish governments, to the governors of several U.S. states, and to the premiers of two Canadian provinces. He’s served as a consultant to private companies, financial institutions and law firms in 29 countries, and has appeared more than 2,300 times as a featured radio-and-television commentator. He appears regularly on ABC, BBC, Bloomberg TV, CBS, CNBC, CNN, NBC, Russian RTV, and the Fox Business Network.

A prolific writer and lecturer, his six books, more than 2,700 professional and market publications, and over 650 private/public sector presentations and workshops have appeared in 47 countries.