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Sorry, Biden: Lower Oil Prices Today Would be a Pyrrhic Victory
Neither Increased OPEC+ production nor SPR releases are a durable answer to high pump prices
To blunt rising prices at the pump, the White House has repeatedly called on OPEC+ to accelerate production additions; but these calls are misguided.
OPEC+ isn’t likely to lift production given longer-term outlooks, with the group generally favouring market stability over short-term price management, and already [admittedly optimistically] forecasting supply surpluses in the months ahead.
US tight oil production—the largest source of non-OPEC+ pre-pandemic growth—is rebounding from the pandemic downturn at a far slower pace than expected, especially given the currently elevated price environment.
The production trajectory of the US shale patch is the single-biggest question in the oil market today and, frankly, prices at or above their current level are likely needed to incentivize the non-OPEC+ production investment we’re going to need as OPEC+ cuts roll off through end-2022.
Oil prices are pretty high right now. Not super high, by any means—but high enough that folks are starting to notice the money leaving their pockets when they fill their tanks. Prices are also high enough for governments to take notice, with the White House making repeated and increasingly firm requests that OPEC+ increase production faster than planned to soften consumer complaints.
However, I would argue that this presidential call to OPEC+ action is misplaced. The producer group yielding to the Biden Administration’s pressure campaign would not durably fix pump price discomfort and, in fact, may actually make the underlying problem worse instead of better.
While admittedly counterintuitive, prices at or above current levels are actually needed to stimulate more non-OPEC+ production investment, which will be required to cover medium-term demand growth as OPEC+ cuts roll off over the next year. While hardly an alliance of saints, OPEC+, and particularly de factor leader Saudi Arabia, is remaining firm on the established production recovery timelines to provide a reasonably stable offramp from COVID shock. The absence of such non-OPEC+ cover would likely prompt much higher prices next year than those currently faced by consumers.
OPEC+ Cuts are Already Managing Oil Prices Pretty Well
Overall, crude’s volatility has paled in comparison to what we’ve seen in other commodities (e.g., lumber, iron ore, steel, copper, coal, or natural gas outside North America, etc.), which saw tremendous run-ups to multiples of previous all-time highs. Oil, meanwhile, reached only half its inflation-adjusted 2008 high (see top chart).
OPEC+ is a big part of why the oil market didn’t experience the volatility witnessed in other commodities. By cutting nearly 10% of global supply in April 2020, oil prices stabilized and the worst of the potential supply-side capacity destruction was avoided.
In an alternative scenario without the OPEC+ supply management, prices would have stayed low enough for long enough to force roughly the same volume of production off the market; however, economically shuttered capacity would have been much harder to restart. This would have prompted an acute mismatch between supply and demand as economies reopened after strict pandemic lockdowns and prices would have spiked even harder—exactly what we’ve seen across other commodity markets.
OPEC+ is now in the process of returning those withheld barrels to market, first in larger chunks and then, beginning in August 2021, at a steady pace of 400 kbpd each month until the cuts have been entirely rolled off by fall 2022. Admittedly, there have been slippages; the group is currently slightly underproducing its quota, mainly due to issues in Nigeria and Angola. But overall compliance has been strong, and the group has thus far maintained a consistent, clearly communicated easing path.
Drilling Down on What Riyadh—er, OPEC+—Wants
While OPEC[+] meetings can often be characterized as exercises in cat-herding, the group‘s overarching trajectory continues to be driven by de facto leader Saudi Arabia, the member with the most production flexibility, greatest spare capacity, and the willingness, in extraordinary situations, to use it’s oil industry to press other members into action. The Kingdom is the longest-term oil supplier imaginable, with massive, cheap-to-produce reserves and, therefore, is motivated less by the price of oil today or tomorrow as by the price of oil over the next two decades. Using this lens, Saudi Arabia—acting through OPEC+—generally prioritizes market stability, looking to avoid prices that are high enough to accelerate long-term demand destruction.
So, wouldn’t Saudi Arabia want to increase production to help lower prices (as the What House has been demanding)? Not necessarily. It is with this long-term lens that Riyadh’s approach to managing a historic crisis can be understood; the oil market likely needs higher prices today to ensure adequate supply and contain price volatility for the period after OPEC+ has wound down its emergency cut.
There’s also the small matter of a seasonal surplus over the coming months expected by most major forecasters, including OPEC+, as seen in the chart above. However, for the purposes of this discussion, that seasonal oversupply just accentuates the price effect that I’m discussing. The same thing can be said about the White House’s pivot toward potential strategic petroleum reserve releases from the US and allied countries: the market just doesn’t need more crude right now.
Shale? More like Snail
The larger issue, in my view, is that production outside of OPEC+—namely in the US shale patch—has yet to rebound to anything resembling its pre-pandemic condition. Far and away the largest source of non-OPEC+ pre-pandemic growth, production in the US fell by 2-3 MMbpd during the opening weeks of the pandemic and remains depressed despite the price of crude reaching its highest level since the 2014 collapse. The US is currently producing 11.5 MMbpd of crude, still 1.6 MMbpd below its February 2020 peak.
Where production in the US shale patch goes from here is the single-biggest question faced by the oil market today. In the past, it was common to refer to a $40-60 per barrel “shale band” (credit to PetroMatrix) inside of which oil prices would bounce around. Lower than $40, shale investment would slow, decline rates would take hold, and production would contract. Higher than $60/bbl, US production would accelerate to a point where gains would swamp demand growth and prices would be forced lower.
We’re clearly well above $60/bbl today and US production is rising at a far slower pace than one would expect—and from a materially depressed base. Oil-directed rig counts are still one-third lower than they were before COVID. And while the efficiency of those online rigs has improved, US producers have been forced to draw down a large backlog of drilled but uncompleted wells (aka “DUCs”) to subsidize the lack of drilling.
Much has been made of these US tight oil producers finding the religion of cashflow discipline after a decade of profligate spending. A less flattering interpretation is that US producers are simply facing the same supply chain bottlenecks as the rest of the economy and it’s kneecapping any potential efforts to lift production. In reality, it’s likely a sticky combination of both tight purse strings and tight supply chains.
Despite this lackluster bounce back to date, all major forecasting agencies now expect US oil production growth to average nearly 1 MMbpd in 2022. Given current [un]responsiveness, that expected target feels unlikely to be met absent continued high prices, which brings us back to why OPEC+ is happy enough with the current stronger-priced environment.
Expect OPEC+ to continue supporting a reasonably high oil price over the coming months given confidence in their established recovery strategy and a desire for market stability. Meanwhile, the big question continues to be around non-OPEC+ producer investment, particularly in the US shale patch. US shale continues to recover post-pandemic but at a disappointing rate, especially given the current price environment. Biden likely won’t see any relief for Americans at the pumps in the short-term—but that’s good because any short-term release likely yields longer-term pain.