Threading the Needle With a Drill Bit
While attention is being directed at a strained G7 meeting in Canada and the upcoming (according to Trump) “one-time event” summit in Singapore, there is something else afoot.
In anticipation of renewing sanctions against Iran and the approach of heavier action against Venezuela, Washington has undertaken a very suspect series of moves to manipulate the price of crude oil.
It is the political equivalent to the magician’s “now you see it, now you don’t.”
The prospect of lower volumes from both countries certainly opens the ability of American operating companies to increase production. That would stimulate a domestic economic sector already benefitting from the Trump Administration energy policy. But it would also run the risk of driving prices down as excess production brought down the market price.
That’s because US contact with the Saudis intent on securing additional OPEC lifting totals began even before the Iran decision. One of the unpalatable results of a sudden drop in aggregate international volume is the likely spike in oil prices. Excess supply, on the other hand, will deflate prices.
As any knowledgeable veteran of oil wars will tell you, trying to hit such a moving target in the middle of pricing pressures moving in contrary directions is more likely to exacerbate the problem.
As a result of continuing robust levels of global demand, the decline in available supply will jack up prices for both crude and finished oil products. That, in turn, will hardly contribute to economic recoveries either underway or politically promised in various US regions.
Rising oil price may be a short-term boost to operating company bottom lines upstream, but the wave of price increases moving into mid and downstream sectors makes for rising costs for other employers in the economy.
It will also in quick measure heat up oil field and related service costs, thereby squeezing producers’ profit margins. In addition, it is quite likely to add the precise inflationary pressure the Fed has been worrying over.
So, this is the tightrope that Washington has apparently decided to walk. I say apparently because a number of the supposed policy participants aren’t sure what is happening next.
With one hand the Trump Administration wants to improve the US oil patch by allowing increasing revenue returns from production. Yet on the other, it needs to restrain prices to avoid residual adverse economic impact in the domestic market, rising inflationary factors, and an expanding wave of secondary and tertiary downstream problems.
This translates into the following, somewhat specious reasoning. Additional US production can be allowed so long as the overall domestic market price (gauged by the WTI benchmark set daily for futures contracts made in New York) can remain in the low $60s per barrel. This is believed by prognosticators as being a sufficient per barrel price to allow producers to remain above water.
Of course, as the rising costs of field operations kick in, that level will be less attractive. Remember, the revenue made by production companies comes from the first arms-length sale of volume coming out of the ground (the wellhead price). That price, in turn is set at a discount to WTI. But that calculation does not provide for the increasing costs of lifting the oil, now beginning to come on line.
However, this increasingly narrow play between allowing additional production in the US while still suppressing loss of profits has three additional concerns, all of which are not boding well to the approach.
Benchmarks & Bottlenecks
First, significant bottlenecks are again forming in the US local pipeline system. While increasing production is moving from the field, more of it is held in effective storage in pipelines and at gathering locations or terminals, rather than moving to end users (refineries) or export to higher priced foreign markets.
This is suppressing the price of WTI and intensifying the spread of WTI against London-set Brent (the more globally used benchmark).
Bottlenecks have traditionally been associated with the confluence of main pipeline networks converging at Cushing, OK. This is the location at which the WTI price is actually set each day (and where I spent formative years darting my bicycle between hundreds of miles of pipelines or dodging oil trucks).
The problem of bottlenecks had been eased by additional pipeline capacity moving in reverse mode to Gulf Coast petrochemical complexes. More recently, the problem has popped up again and has extended to other locations, primarily because of the rise in emphasis on rapid production increases from the Permian.
Second, the primary drain off of excess US production has become export. Increasing pipeline bottlenecks likewise adversely impact the transfer of crude for export. Yet there is an even more important problem emerging.
American oil export has little genuine additional capacity available. Currently, the daily aggregate total is running as high as 2.5 million barrels. There may be a few hundred thousand still available, but that’s about it. That the US is already the world’s leading exporter of processed oil products limits flexibility even further.
Additional leverage will be coming on line as export infrastructure expands down the Gulf Coast from overextended Houston and the Channel to Corpus Christi. However, that is going to take time.
All of this means a shortfall in worldwide crude production levels does not translate into much additional benefit for US companies.
Third, the price of oil is not set in the US market. It is global and skewed to developing areas, specially Asia. American market considerations have something to say about all of this, either through export or import levels.
As to the latter, imports (especially from Canada) occur when there is a cost advantage to enhance local refinery margins. Otherwise, the largess provided by shale and tight oil reserves provide for domestic market needs.
Too Many Tightrope Walkers, Not Enough Nets
And that brings us back to why the US has been talking to the Saudis. As production continues to fall in Venezuela and is expected from Iran, there is additional space for OPEC and Russia increasing their own production.
In fact, if Washington’s sole concern was to control end prices for US industrial and commercial consumers, that would be the policy choice. Of course, rapidly increasing production from other sources would restrain price increases in end markets, but also suppress American domestic production profits.
Once again, the tightrope emerges.
Venezuela is experiencing a collapse in production, with both extraction and exports diving to levels not witnessed in almost three decades. National oil company PDVSA is on the verge of insolvency, with defaults on contracts and bonds cascading. A declaration of force majeure appears inevitable, while the company continues to lose control over assets to Russian and Chinese entities in its inability to meet debt obligations.
Projecting the loss of production is always difficult in such circumstances. But my latest estimates put it at a staggering 1.6 million barrels a day over less than the past 18 months. And that is without any push for additional US sanctions against Caracas.
I further estimate that, once US sanctions take hold against Iran, the resulting reduction in export availability may add at least 600,000 barrels to the daily shortfall. But such an impact will not happen for some time: it will take months for the threatened sanctions to be in place and the drawdown of current Iranian stored excess oil to occur, all assuming the failure of pushback from other Western countries intent on saving JCPOA (the Iranian nuclear deal).
Nonetheless, even before these additional factors are in place – and forgetting ongoing situations leading to a decline in Libyan, Nigerian, and Mexican production – there is some space for additional global production without significantly depressing prices.
Yet the Saudis are not interested in lowering prices too much, given the need to maintain as high a crude price as possible in advance of the Aramco IPO. The revenues from that issuance will depend upon the market value of Aramco reserves still in the ground.
Moreover, to the extent that the opinion among my Russian Minenergo (Ministry of Energy) sources is correct, the Kremlin is again considering a supplemental issuance of shares in state oil company Rosneft. Such a move is likely to be dependent on the success of the Aramco move.
This means that neither Saudi Arabia nor Russia has an interest in depressing oil prices too much, especially given the export quality of their crude which trades at significant discount to Brent.
These various considerations place the success of a tenuous US policy to play both ends of oil pricing from the middle as highly speculative. If this is a tightrope walking scenario, it is one without a net.
Stealing from Peter to pay Paul rarely works in the real world.