Like the Terminator returning after being blown apart, this oil market slump is proving hard to kill. At the end of last week, prices, which had been very stable all year suddenly plunged by 8 per cent. This shocked Opec representatives at the industry's big CeraWeek pow-wow in Houston, but it may not be all bad news for the big oil countries.
Brent crude fell to US$51.37 per barrel from $55.90, its lowest closing price since November 29, while the US’s West Texas Intermediate was even harder hit. The slump came on the back of news showing US crude stockpiles rising to a record high of 528 million barrels, capping nine consecutive weeks of gains. The market was also nervous about signals from Opec ministers that the current deal on production cuts might not be extended after the organisation’s May 25 scheduled meeting and continuing increases in US shale oil drilling and production.
The build in inventories was, in itself, not so surprising. US refineries are going through spring maintenance after running flat out for months, so their crude use is down. It does not necessarily signal that American oil output is stronger than shown in official figures. The International Energy Agency believes that Opec cuts have helped developed-country stocks drop below 3 billion barrels for the first time since December 2015, although China and other emerging nations continue to add inventories.
The futures curve – the price for buying or selling oil at a specified month in the future – currently has an odd structure. Last week’s slump has put the short-term curve into contango, where the future price exceeds the prompt price. From next February until December 2019, the curve is in backwardation, with longer-dated prices below near-term prices. And then the curve reverts to contango, rising to around $57 per barrel for Brent crude by 2024.
These might seem like arcane technicalities but they have an important impact on oil market players. Anyone with physical oil in storage can make a guaranteed profit by holding on to it until February, after allowing for the cost of storage, insurance and financing. But if the near-term curve enters backwardation, they would do better to dump their stocks, bringing down the prompt price but easing the worldwide glut of inventories.
Shale oil wells typically yield most of their output over their first year or two of operations, before production dwindles. Over the past couple of years, the entire forward curve was in contango, so allowing shale producers to lock in higher prices for the useful life of their wells. Whenever Opec did raise the prospect of production cuts, without actually delivering, as in last April's failed meeting in Doha, futures prices would jump above the prompt price, making hedging easier.
But now the market dynamic is different. Part of Opec’s objective has been to move the near-term curve into backwardation, with its production cuts raising the prompt price while the prospect of a breakdown of the Opec deal keeps prices weaker a few months out. This makes hedging less attractive.
This is entirely consistent with a Reuters report on Thursday that advisers to the Saudi energy minister, Khalid Al Falih, told US shale oil executives that Opec would not necessarily extend its cuts and take all the burden of market rebalancing. This message, no doubt intended to be leaked, dampens prices a few months out. The latest plunge is also a useful reminder to shale companies and financiers that their investments are not a sure bet.
Opec’s concurrent efforts to dampen the shale boom, preserve its market share, draw down inventories and restore prices to a level it finds reasonable, have moved the market towards the elusive “balance”, but very slowly. An extension of the production deal in May, likely but requiring further compromise, is essential to the current strategy. Otherwise we can expect yet another twitch from the stubbornly undead price slump.
Robin Mills is the chief executive of Qamar Energy and the author of The Myth of the Oil Crisis.
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