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Recapping March Oil Price Moves And What Now?

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It’s been almost 2 months since my last look at the price dynamic. I can’t say that any of the developments have been surprising. All the volatility happened on the front end of the cure with the 18m+ durations moving lower but not nearly as aggressively as the spot and 3m. We are still looking at Brent around $55-57 and WTI at $47-48.

The key developments over the period were the anticipation and eventual resolution of the Iran talks as well as the major negative push by Wall Street analysts (Goldman mostly) of the “cheap commodities” idea and the fact that we are running out of storage for oil both in Cushing and in VLCCs which may cause a glut as the demand for storage has been a significant part of demand pick up after the turn of the year.

I think whatever happens in the market, the best way to approach it and to evaluate for any given development, whether for the long term or not, is to refer back to the framework I outlined in February. That is – is this development impacting the long term marginal cost of production, market structure or supply/demand balance (including new discoveries, economic growth, technology change etc.)? Using this approach we can clearly see that the Iran factor is significant on 2 counts – it creates more supply in the market as well as potentially a new dynamic within OPEC which may alter the market structure. Whereas neither the storage nor the Wall Street coverage fit in to it.

Iran has been supplying oil to the world market despite the sanctions. So it’s not like there will be a glut of Iranian oil hitting the market in June. However Iran was not able to invest into their oil industry and grow production over the last decade or so. So the key development here is that there may be 2-3 million barrels a day that can be added to global production in the next 3-4 years. That is not insignificant (it’s 3.5-4% of total). This has the potential of offsetting any pick up in demand in the emerging economies in the region.

Whats even more interesting, Iran is currently involved in a fairly open confrontation with the Saudis over Yemen and Syria. This makes OPEC meetings more interesting. In prior years, Iran would comply with any output restrictions as they couldn’t get majority of the money for their oil anyway. Now though, not only do they get a windfall of their frozen assets (all that oil money for the last decade), but Saudis are in a more precarious position as they have started spending their endowment funds. If there is a chance of significant non-compliance with so many major producers open to the idea (Venezuela, Nigeria, Angola and now potentially Iran), then what is the point of OPEC? Certainly any move by Saudis to restrict supply will still be significant, but the proof would be in compliance. If compliance will be low, market becomes more open and the long term price will be lower.

When it comes to storage though there is no real impact on market demand. That oil will be consumed at a later stage and its just a mechanism for redistributing demand over time (and letting people make a few bucks along the way).

As a result I am getting more confident in my original view yet. There is nothing on the horizon that will push the price over $60 in the foreseeable future (2 years), and I would not rush to be any more optimistic just yet.

The interesting side effect of a subdued environment like that as well as the potentially non-compliant OPEC is a potential race to the bottom on costs which would be tough for producers but would give us (consumers) a better deal but also will enable us (as observers) to figure out what the actual Marginal Cost of production is. I will address this over the next few posts.

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