28 April 2018

Has a Bull Oil Market Returned?

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Saudi Arabia and other major oil producers may reach their goal of reducing global oil inventories to their five-year average by the next OPEC meeting, scheduled for June.
With that part of the strategy complete, Saudi Arabia is seeing other reasons — including boosting the valuation of Saudi Aramco — to support higher prices. But it's not just Saudi Arabia's strategy that has helped bring oil prices to their highest level since November 2014; structural factors that have leaned heavily on oil producers like Venezuela and the prospects for production in Libya and Iran have contributed to the higher prices.

A crude awakening may be no more. De facto OPEC leader Saudi Arabia is reportedly targeting oil prices near $80 a barrel — or even $100 a barrel. It has emerged as one of the loudest price hawks among oil producers, though other OPEC producers have pushed back on the higher targets. This stance, along with a number of other factors, has helped boost oil prices to their highest level since the fateful OPEC meeting in November 2014 when Saudi Arabia refused to cut its oil production, opting instead to drive down the price of oil to curtail rising U.S. tight oil production. Oil prices flirted with $75 a barrel on April 19. On April 20, major oil producers will descend on Jeddah, Saudi Arabia, to discuss oil production cuts implemented last year to reduce oil inventories. During this meeting, Saudi Arabia is likely to outline its views about where it believes oil prices should head.

The Big Picture

"A Crude Recovery," one of Stratfor's main themes for more than three years, has tracked the decline of energy prices since their June 2014 highs. Saudi Arabia appears to be backing higher oil prices, and the market's structure could be supporting them. If this is the case, then the consequences of higher oil prices — just like lower oil prices — will be global.

A Shift in Tone

The bull market's appearance is not driven by just one factor, indicating that perhaps reasonably high oil prices (that is, about $65 a barrel) are here to stay. Saudi Arabia's tone here is critical. Recently leaked financial statements of the Saudi Arabian Oil Co. (Saudi Aramco) show why Saudi Arabia has been aggressively pushing for higher oil prices even while some oil producers, like Iran and Iraq, have been skeptical of its moves.

Saudi Aramco's financial figures showed that it was the most profitable company in the world for the first half of 2017: It earned a profit of $33.8 billion for the period, beating Apple by nearly $5 billion. The leaked statements also showed that Saudi Aramco had virtually no debt and that its production costs per barrel were just a fraction — $4 a barrel — of its peers. But investors were left concerned. Despite the profit margins, on a per-barrel basis, the dividend Saudi Aramco would have paid out would have been smaller than its multinational oil company peers because of its high tax and royalty rates. This means a realistic valuation of Saudi Aramco may be around $1 trillion to $1.5 trillion.

That figure is far below the $2 trillion valuation that Saudi Crown Prince Mohammed bin Salman has targeted and the one he may need in order to sell his plan of an initial public offering (IPO) to the House of Saud. Moreover, this valuation would confirm earlier reports that global investors had a lukewarm response to Salman's target valuation during his recent trip to the United Kingdom and the United States. One way to boost Saudi Aramco's valuation, of course, is to boost oil prices; the company's profit margins, as one would expect, are highly sensitive to oil prices. And because Riyadh wants to sell only 5 percent of Saudi Aramco through an IPO, every bit counts when it comes to boosting the company's valuation. High oil prices also mean more dividends, royalties and taxes for the Saudi government, which has seen its expenditures balloon now that it has reversed the austerity measures imposed under previous budgets.

Last week the International Energy Agency also noted that oil producers could soon declare that they have successfully met their goals to reduce global inventories. The Paris-based agency said that by May, global oil inventories in Organization for Economic Cooperation and Development countries will reach their five-year averages, the stated goal by oil producers. But the strategy is shifting. Saudi Arabia, for example, has been trying to move the goalposts away from targeting the five-year averages and toward stimulating global investment in the oil sector. Saudi Arabia is worried it will not be able to make up for a shortfall in new production coming from 2020 to 2022 and thus will fail to maintain its policy of keeping around 2 million barrels a day of spare capacity. Because of this — and because of its IPO goal — Saudi Aramco is pushing for higher oil prices, even if it means stimulating more U.S. tight oil production.
Key Implications for the Oil Market

Saudi Arabia's policy is uniquely influential on the global oil market. While the global deal to cut oil production has seen OPEC and non-OPEC oil producers cut production by 2.4 million barrels a day between January 2017 and March 2018, Saudi Arabia and its core Gulf Cooperation Council allies are home to the vast majority of actual spare production capacity that could reverse the structural factors supporting high oil prices. Even though U.S. oil production has risen to 10 million barrels a day (it plateaued between November and December 2017 near that level), the United States alone cannot make up the gap, especially as the global economy remains strong and is supporting high demand growth. The majority of production taken offline by other countries, like Mexico, has largely been from natural declines and cannot easily or quickly be brought back to life.

Venezuela has been one key reason for the decline in oil inventories and the rise in prices. Though it promised to cut production by only 95,000 barrels a day, Venezuela's production has collapsed by nearly 600,000 barrels a day — roughly the same amount as the decline by Saudi Arabia — to around 1.5 million barrels a day since the deal came into place. And that oil production is not coming back and could fall under 1 million barrels a day by the end of the year. As the government of President Nicolas Maduro has tried to stay in power, it has prioritized its short-term stability over maintaining production. For example, late last year Maduro appointed Gen. Manuel Quevedo as director of Petroleos de Venezuela and head of the Oil Ministry. Quevedo's appointment formalized military control of the oil sector. The move ensured military loyalty to the Maduro government, likely by allowing the armed forces more direct access to oil revenues, but it also wreaked havoc on operational efficiency. This coupled with tightening access to the dollars needed to import light oils to dilute and ship its heavy oil production will continue to cause Venezuela, once Latin America's largest oil producer, to see a decline in output.

Iran's prospects might not be any better. Iran is not a part of the oil cuts, but the United States may pull out of the nuclear deal with Iran and reapply sanctions on the country's oil sector. The Trump administration has given the European Union and Congress a May 12 deadline to address its concerns about the Iran nuclear deal. The European Union appears willing to place more sanctions on Iran for its regional behavior and its ballistic missile program, but it does not appear willing to budge on the deal's so-called sunset clause. If the United States reintroduces sanctions to their fullest force, European banks — and other countries — would be banned from financing Iranian oil purchases with sanctioned Iranian banks. There is a waiver process, but the reality is that this could hit Iran's oil exports. In 2012, Iran's oil exports declined by roughly 1 million barrels a day. This time around, there won't be as much sanctions cooperation between the United States and the European Union, or even China, but oil exports will decline.

The questions around the health of Khalifa Hifter, leader of the Libyan National Army (LNA), also has key implications for the oil market. Libya remains mired in civil war, split between three competing governments and a myriad of localized militia groups that see control of Libya's oil infrastructure as key within the theater of competition and leverage against one another. The Libyan civil war brought the country's oil production down to as low as 250,000 barrels a day in August 2016. But Hifter has played a critical role in turning that production around. The LNA took control of the oil terminals in the east and now control nearly 80 percent of Libya's source field. Underneath the LNA, however, the divisions remain and are likely to re-emerge, which means control of oil fields — and potentially shutting them down — could return. Already signs of cracks have emerged as the LNA's chief of staff, Abdel-Razek al-Nadhouri, survived an assassination attempt April 18.

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