The History of the Current Oil Crisis and What to Expect Now?

Crude oil is in bear market territory, down more than 21% from the yearly highs reached on January 1 of this year. So, is this a good buying opportunity or is this the start of a bigger decline? To analyze this in detail, we have to first study the reasons for crude oil’s fall from above $100 per barrel levels in 2014, the subsequent recovery from its lows of under $30 per barrel in early 2016 and the recent gloom that is threatening to push prices back into the $30s per barrel levels again.

Key Points

  • Huge US shale oil boom led excess supply started the current oil crisis
  • Major oil producers depend on oil revenues to fund their fiscal budgets
  • Iran and Saudi Arabian rivalry scuttled the first deal in April 2016
  • OPEC continued to talk prices higher in 2016
  • Crude oil prices skyrocketed on the announcement of the OPEC production deal
  • US crude oil inventory remains stubbornly high even after OPEC production cuts
  • Markets daring OPEC to cut deeper, until then oil will trade with a bearish bias

The US shale oil boom

High crude oil prices in the last decade, barring the plunge during the financial crisis was boom time for the US shale oil sector. As a result, US crude oil production spiked from about 4.8 million barrels per day (bpd) in 2005 to 9.3 million barrels bpd in 2015. Demand growth could not catch up to the supply addition, leading to a glut. Consequently, oil prices began to plunge.

Saudi Arabia had a new competitor in the form of the US shale oil producers. However, estimates by the consultancy firm Wood Mackenzie put the US shale oil ‘break-even price” at around $65-$70 per barrel. Therefore, Saudi Arabia, in 2014, devised a strategy to continue pumping oil in order to retain market share. They wanted prices to fall below the breakeven of shale oil drillers forcing them out of business. As a result, prices plunged from above $100 per barrel in mid-2014 to multi-year lows of about $26 per barrel in February 2016.

Low Oil Prices Hurt Major Oil Producers, Including OPEC

Though Saudi Arabia managed to send a number of US shale oil drillers into bankruptcy, they could not wipe them out completely. With various cost cutting measures, new technology advances, and smart hedging strategies, many US shale oil companies brought their breakeven price down from $70 per barrel to about $40 per barrel.

On the other hand, the major oil producers who were depended on crude oil prices began to suffer, because their fiscal budgets were bleeding. The OPEC nations needed a much higher price for breakeven, as shown in the chart below, hence, the smaller nations began pressurizing Saudi Arabia to cut production to balance the markets.

OPEC Member Fiscal break-even Fiscal deficit(% of GDP) Million barrels per day Spare capacity(% used)
Algeria $96.1 -13.90% 1.11 2.64%
Angola $110 -3.50 1.79 2.22%
Ecuador n/a -5.10% 0.53 5.26%
Iran $87.2 -2.90% 2.88 20.83%
Iraq $81 -23.1% 4.2 6.94%
Kuwait $49.1 1.20% 2.73 1.42%
Libya $269.00 -79.10% 0.43 20.00%
Nigeria $122.70 -2.80% 1.9 6.77%
Qatar $55.50 4.5% 0.67 5.71%
Saudi Arabia $106.60 -21.60% 10.25 17.13%
UAE $72.60 -5.50% 2.89 2.04%
Venezuela $117.50 -24.40% 2.38 3.21%

Table sourced from CNBC

Saudi Arabia and Russia Announce Production Freeze in February 2016

Saudi Arabia was also struggling with prices stuck between $40-$60 per barrel. Hence, on February 2016, Russia and Saudi Arabia announced an agreement to freeze production. This put a bottom in place and crude oil prices rallied from the lows. The announcement couldn’t have come at a better time as WTI crude oil had hit a multi-year low of $26.05 per barrel on 11 February 2016.

Oil markets were further encouraged when the other OPEC members and non-OPEC producers agreed to meet in Doha on April 2016 to ink a deal on production freeze.

Saudi Arabia and Iran Tensions Scuttle a Deal in Doha on 17 April 2016

Saudi Arabia and Iran have been at loggerheads with each other since the Iranian Revolution in 1979. Though both nations are ruled by the Islamic scriptures, Saudi Arabia is Sunni dominated, whereas, Iran is a Shia majority.

Both want to be seen as the torch bearers of the Islamic world, hence they are in confrontation with each other to establish regional supremacy. Both these nations are on the opposing sides in the two ongoing conflicts in Syria and Yemen.

During the Doha meeting, Saudi Arabia stressed Iran also to commit to a production freeze. However, Iran – which was allowed to sell its oil only in January 2016 after the Western world partially lifted the sanctions – was adamant to increase its production to pre-sanction levels before even considering any production freeze.

Saudi Arabia’s tough stance was attributed to its then Deputy Crown Prince Mohammed bin Salman, who is known loathe Iran. The meeting ended without a result.

Between April and November, the oil markets remained in a range with hopes alive that OPEC and Russia will arrive at a deal to limit production to balance the markets. Whenever oil prices fell, OPEC kept propping prices higher talking about a possible production deal.

OPEC and Non-OPEC Reach a Deal on November 30

After months of deliberations and negotiations, OPEC finally agreed to cut production by 1.2 million bpd – first production cut in eight years – on November 30. However, Nigeria and Libya were exempt from the deal, while Iran was asked to only freeze production – at slightly higher levels than its October production – rather than cut. Saudi Arabia, the largest OPEC producer agreed to cut 0.5 million bpd, Lion’s share of the total 1.2 million bpd planned. Crude oil prices rallied over 10% following the announcement of the deal. Oil further received a boost when Russia also joined the deal and both the OPEC and non-OPEC producers agreed to cut 1.8 million barrels of oil.

Crude Oil Prices Remained close to $50 per barrel Following the Deal

History says that OPEC members cheat and report false numbers during production cuts. Hence, the analysts were skeptical of the success of the deal this time. Nevertheless, as reports emerged of a high level of compliance by the OPEC members, oil markets were further encouraged that the supply glut will reduce.

However, the US shale oil drillers had other plans. They had been increasing production and adding oil rigs taking advantage of high oil prices. They once again proved that the balance of the oil markets had changed.

The mantle of ‘Swing Producer’ – a large producer increasing or decreasing production in order to keep the oil markets balanced – was not with Saudi Arabia alone. Due to the short time needed to stop or start production, the nimble footed US shale oil producers were equally capable of increasing or decreasing production.

US oil production hit a low of 8.42 million bpd in the first week of July 2016, from the peak of 9.61 million bpd in June 2015. That was a drop of about 12.38% in about 13 months. However, as crude oil prices rallied to $50 per barrels, US crude oil production started to recover quickly – much faster than analysts expected. By the week ending 16 June 2017, US oil production has again bounced back to 9.35 million bpd. Analysts are now predicting US crude oil production to reach 10 million bpd by the end of this year.

The US crude oil inventory has remained stubbornly high. At 509.1 million barrels – as on 16 June 2017 – it is ruling close to the lifetime highs of 533.97 million barrels, well above the five-year average. Thus, the crude oil traders have lost hope that the current production deal is enough to rebalance the markets in the wake of rising US, Libyan and Nigerian crude oil production. Therefore, crude oil prices started falling and are threatening to go below the $42 per barrel levels.

The Oil Production Deal is in Danger of falling apart

Though OPEC and Russia agreed to extend the deal until March 2018, the recent elevation of Mohammed bin Salman as the crown prince of Saudi Arabia is likely to flare middle east tensions, which is already on the rise after Saudi Arabia and its allies broke diplomatic ties with Qatar recently.

Additionally, the frustration of falling crude oil prices when OPEC members are either freezing or cutting production will increase calls for Nigeria and Libya to be bound by a limit. Similarly, Saudi Arabia, under the new crown prince is likely to pressure Iran to cut production. If the above happens, the deal is likely to fall apart.

So, What is the Future of Crude Oil Prices?

Along with demand and supply, crude oil prices are also determined by the underlying sentiment. Currently, the sentiment is running weak as the analysts are not confident that the supply cut can be reduced without some drastic measures. Hence, until the OPEC springs some surprise, crude oil prices are likely to remain range bound with a bearish bias, keeping an eye on the US oil production and another of the US crude oil inventory data.

Featured image from Shutterstock

Rakesh Upadhyay is a Technical Analyst and Portfolio Consultant for The Summit Group. He has more than a decade of experience as a private trader. His philosophy is to use technical analysis for momentum trading and fundamental analysis for long-term positions. Rakesh likes to keep himself fit by lifting weights and considers himself to be a spiritual person.