Oil prices will fall again?

ARTICLE: Oil prices have staged an extraordinary recovery. In seven weeks the price of West Texas Intermediate, WTI, has risen $80 dollars! This is when you compare the current price, $40, with a negative $40.32 on 20th of April. The benchmark Brent has also doubled since that time. The million dollar question, however, is whether this rally is sustainable? There are various factors that will determine the trajectory of markets. As prices rise Shale production might come back online. Also we shouldn't be ignoring the brewing tensions between China and the US that will culminate in another bout of trade war. Finally, the future of oil deal is still uncertain, failure to come up with an exit strategy will cost OPEC+, and oil prices, dearly.

One of the dilemmas that the OPEC+ producers face is that despite their intentions and actions to capture the market share from Shale, they simply cannot keep the later down or out of the game. This is a cycle: OPEC (read the Kingdom of Saudi Arabia) launches an oil price war that results in fall in production in the US Shale industry. However, as production declines, the prices start to rise. As this happens, the Shale industry bring back the lost barrels and we all arrive at square one once again.

We are observing a similar situation. As (WTI) prices touch $40 many in the Shale industry are planning to restart production. Libya is restarting production to the effect of 300,000 barrels per day. The magnitude of oil passing through the Energy Transfer's systems had fallen by 20 percent from March and May. About half of that amount has come online again. WPX Energy Inc. is planning to restore 45,000 barrels per day of its production while Parsley Energy Inc. intends to recover 26,000 barrels.

Paul Hickin, Associate Director at S&P Global Platts, said that "At current prices we are in a bit of limbo, neither high enough to really incentivize shale and not low enough to do much more damage to US producers. While the adage companies go bust, their asserts don't applies in this situation, you have to wonder whether US shale can and will respond in the same way once prices rise. The new normal for shale may look a little different as investors will want returns and not growth for growth's sake".

As production stopped on existing wells about 1.75 million bpd went offline. IHS Markit estimates it to recover by September. However, oil demand will be 13 percent less than last year. How Shale responds to these factors will determine the future of US oil production.

Another factor that we need to keep in mind is the trade war between US and China. Many observers thought that after the pact was signed on 15th January 2020 that the trade war over for good. But soon after that the ongoing pandemic settled in making it almost impossible for China to fulfill its promise to buy additional goods and services worth $200 billion. The provision of a snap back clause makes the deal tenuous.

If this isn't enough then recent overtures by Chinese government that includes the controversial Hong Kong bill, the standoff in Laddakh and an exchange of heated rhetoric between US and China -all of these might result in some tensions between the two largest economies in the world. Given that it is election year President Trump will certainly look for some political posturing and use China as a scapegoat. Only recently the Trump administration has once again tried to hinder Huawei's path to assume global leadership role in Mobile telecommunication industry. The administration recently banned chip-makers from the U.S. from supplying to Huawei. The new rules entail that chipmakers will require a license before they plans to sell to companies that are on US blacklist.

Owais Arshad, an expert of global economic sanctions, shared his views on the trade war saying that "Relations between the US and China have rapidly deteriorated. The US administration, and Congress are both looking to recalibrate relations with Beijing. The potential imposition of additional tariffs is only one aspect of a broader strategy of realignment which is becoming increasingly evident from a US perspective."

As a part of a general framework of "strategic competition" between the two powers, the US position is now one of, "confronting China's market-distorting forced technology transfer and intellectual property practices by imposing costs in the form of tariffs levied on Chinese goods coming into the United States. Those tariffs will remain in place until a fair Phase Two trade deal is agreed to by the United States and the PRC." We can certainly sense trouble in future!

Finally, the future of OPEC+ deal is closely associated with the demand story. And here is where the problem lies. Oil demand recovery might take too long to recover and that spells trouble for the OPEC+ countries as they don't seem to have an exit strategy for their current deal. Given the fact that these production cuts cannot go on for over, the absence of a clear strategy to end these might put the markets in turmoil.

Russia already seems to endorse the idea of gradually increasing production. Other OPEC countries need revenues too. In fact the de-facto leader, KSA, itself is suffering from very low reserves and budget deficits. Total reserves in KSA are $464 bn now, with only $164 bn left as fighting reserves; the budget deficit is $9bn. KSA learned a lesson in 2014 - it will not want to repeat it again.

Demand recovery will be slow, as IHS' Daniel Yergin said. IEA estimates a loss of 15mbpd in June and about 9mbpd in oil demand for the whole year; this might exacerbate if in case we see a rise in cases as second wave of the virus strikes different parts of the world.

For rest of the year, it will be an interplay of the above factors that will determine where prices end up. Observers need to pay a close attention to signs of recovery; global economic growth, Shale production, trade war and OPEC+ strategy.

Copyright Business Recorder, 2020