If insanity is doing the same thing over and over and expecting different results, then sanity must be the reasonable expectation that repeat actions have repeat effects. What happens then, when long observed causal relationships break down? When an impressively broad OPEC and non-OPEC production cut doesn’t send prices soaring?
At that point, it’s worth re-examining old orthodoxies and looking again at what constitutes a sane approach for oil companies.
A lacklustre response
In 2008, with prices languishing in the thirties OPEC agreed a 4.2 million barrels per day (Mbd) production reduction, spread over three different cuts. Some didn’t fulfil their cut quotas, but Saudi Arabia made huge efforts and the oil price climbed – slowly at first, but eventually reaching $100 per barrel (bbl) and staying above that mark until 2014.
If you look at 2001 and 1998, the pattern is similar. The oil industry is accustomed to seeing OPEC production cuts as a tried and tested method for boosting the oil price. There may always be scepticism that everyone will stick to their side of the bargain and comply, but to the extent that countries do, there’s always been market confidence in the efficacy of cuts.
So, what’s happened since the production cut this time around?
On November 29, prices for Brent were at $46.38. The next day, OPEC and other key oil producing states agreed to cut production by 1.8 million barrels per day for an initial six months, commencing January 1. By close on December 1, Brent was $53.94.
At first glance, this seems like quite the swing and potentially the start of an impressive recovery, but there are reasons to be sceptical.
Firstly, look at prices in October. That month started at $50.89, hitting $53.14 on the 10th. Prices then dipped heavily in November, largely due to widespread pessimism that OPEC would reach a deal. When it did, prices went straight back up to where they’d been before that slump, but not a great deal higher.
Secondly, look at what they’ve done since. Since their post-deal climb they’ve pretty stubbornly stuck to a $53-$57 corridor that doesn’t look like moving much in the short term. As of the 1st of March, Brent was at $56.36.
Yet, on the basis of this evidence, it’s still possible that we’re still in the early stages of a slow but significant rebound. I don’t think so, though.
A compliance surprise
In the past, some cartel members have been patchy about sticking to the stated cut quotas. For this reason, some of the price responses have perhaps been a little less pronounced than headline figures would have suggested.
However, this deal has been historic for two reasons. Firstly, it’s the first in a long while to include a significant number of major non-OPEC producers such as Russia. Secondly, the parties to the deal are, as a whole, sticking remarkably close their promises.
In fact, both the IEA and OPEC itself have pointed to compliance rates of around 90%. Compared to December, daily output across OPEC in January was down 890,000 barrels per day (bpd).
So this deal was unprecedented in terms of depth and adherence. You would be forgiven for expecting a pronounced, or at least steady, oil price resurgence, for the bears to go into hibernation and the bulls to run rampant.
How did the market react? In February, Brent dropped 0.56% to $56.38.
A changing wind
Why the muted market response? Well, for a start the global market is still hugely oversupplied. It will take a while for any production cuts to start to bite chunks out of stored global stocks.
We also have the much-publicised ramping up of US shale as a spanner in OPEC’s works. The ability for the cartel’s biggest rival to raise low-cost production at any time to capture any ceded ground means that traders can’t be confident that global production will stay cut. OPEC’s stubborn refusal to reduce production following the 2014 downturn has been widely interpreted as an effort to drive these producers out of the market and protect market share. The November deal has widely been interpreted as an admission of failure.
Finally, there are long term trends that might make the market wary. Increasing international climate change commitments constrain the role for fossil fuels just as alternative technologies such as electric vehicles and renewable energy generation begin to mature or more aggressively go after market share.
Opinions differ on just how much of an effect each of these trends will have, but combined they look set to weigh on the oil price for a long time, with OPEC and its allies powerless to do much about it.
Most predictions now are for a prolonged period of $50-60 oil, with potential dips and peaks into the $40s and $70s. Few are willing to bet on a more dramatic rebound.
A rational response
Oil companies – upstream, midstream, downstream – can’t repeat responses to old production cuts. They won’t have the same effect. They can’t double down and do nothing, or anticipate a spending spree when oil reaches triple digits again. Trading desks can’t pick contracts based on expected imminent price rises.
With prices hovering around a fairly narrow corridor for the foreseeable future, now is the time to think soberly about the sane thing to do. Companies should look carefully at margins and accept they will need to find new, creative ways to differentiate themselves and create opportunity.
For example, we’ve seen a big increase in joint ventures in the industry – both in terms of new physical upstream projects and trading operations. Often these bring together bigger and smaller industry players that previously wouldn’t have had much cause for cooperation.
Now, in straitened economic times, the smaller players are looking for the financial clout of bigger rivals. The top tiers for their part, are more risk-constrained in response to prudent investor caution. They need the freer approach to risk the smaller partner can take.
Another trend is a newfound creative flair with contracts. With margins squeezed and all other things being equal, it’s difficult to eke out a competitive edge. Many are adjusting credit and payment terms to be more smart about cash-flow or increase competitiveness in a deal.
It’s encouraging to see so many in the industry doing the sane thing and finding new ways of operating.
A consequence
The upshot of these kind of changes through, is that life becomes a lot more complicated. Risk is more diverse and difficult to track. Varying credit terms produce varying credit risk from buyers.
The net amount of data to sift through and analyse increases, as do the chances of something slipping through the cracks.
Add to that the fact the oil markets themselves are becoming more complicated. For example, Dated Brent from Rotterdam is getting its own benchmark (Dated Brent CIF Rotterdam), no longer exclusively pegged to the standard North Sea Dated Brent benchmark. This allows for more fine-grained analysis, but adds to the already steeply increasing complexity.
Though it may seem counterproductive when trying to zealously protect margin, an investment in technology can be a great help dealing with this. As the volume, complexity and connectedness of data increases, legacy risk management systems are less and less able to cope. Newer systems will help firms ensure the risk is managed appropriately, and formerly top-tier-only technology is often now available in streamlined, standardised versions or via the cloud to extend this functionality throughout the market.
So, oil companies are finding themselves in a strange new place: the market isn’t responding to OPEC cuts as it once did, so it seems quite insane to continue to act in the same manner. But with tightening margins and other shifts in the market making for a tricky environment, the sane response seems to be to do something different. Don’t bet on a steep rise in the oil price based on the cuts, instead, double-down on the margins and look for efficiency and competitive edge wherever possible – and put the tech in place to handle that. That’s what sanity looks like in 2017.
Amrik Sembi is head of liquid and bulk commodities at OpenLink, a developer of software solutions and support services for trading, risk management, financial and operations professionals.
