Why Oil Markets Are Changing

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Charles Mason of the University of Wyoming and Craig Pirrong from the University of Houston discuss why oil markets are undergoing fundamental change.

U.S. consumers and businesses are bracing for higher oil prices in the coming summer months as demand swells. The price of a barrel of oil has been steadily rising since a low point of $42 (for WTI crude) and $50 (for Brent crude) in late December to current levels of about $66 and $73, respectively.

OPEC and major oil producers like Russia continue to attempt to maintain prices by preventing a supply glut with caps on how much they produce. However, those attempts are increasingly less effective than in earlier years, thanks to infighting within the OPEC cartel and violations of production-sharing agreements.

What’s more, Russia, too, appears likely to renege on its agreement to cut oil production. Saudi Arabia has borne the bulk of the responsibility to keep prices and production in check, but big producers like Iran, Libya and Venezuela could frustrate the best laid-out plans with covert export deals, exemptions or distress sales.

Knowledge@Wharton explored the outlook for oil prices and production with Charles Mason, chair in petroleum and natural gas economics at the University of Wyoming; and Craig Pirrong, a professor at the at the University of Houston, who is also director of the Global Energy Management Institute there. They shared their insights on the Knowledge@Wharton radio show on SiriusXM. (Listen to the podcast at the top of this page.)

Below are key takeaways from their discussion.

More Driving after the Winter

Gasoline retail prices typically go up in the summer months because of higher demand. “You see this every year, and it’s largely driven by the fact that as we pull out of the depths of winter, people just drive more,” said Mason, who is also associate dean for research at University of Wyoming. That greater demand for gasoline translates into greater demand for crude oil.

“As we pull out of the depths of winter, people just drive more.” –Charles Mason

However, vehicle owners won’t feel too much of a pinch at the pump. Pirrong noted that the U.S. Energy Information Administration (EIA) in its latest forecast has predicted higher gasoline retail prices this summer but somewhat lower than last summer. It expects gasoline to retail for $2.76 a gallon this summer, compared to $2.85 a gallon last summer. For all of 2019, the EIA said it expects U.S. gasoline retail prices to average between $2.60 and $2.71 a gallon for various grades. “[That] would result in the average U.S. household spending about $100 (4%) less on motor fuel in 2019 compared with 2018.”

Users Are Mitigating Risks

Businesses like airlines and oil producers manage their fuel price risks by using derivatives and futures markets, Pirrong noted. “They have the potential to cushion the impact of price fluctuations for those that are producers and/or consumers of energy products. Added Mason: “Speculators do serve this very important role of smoothing out and arbitraging out what otherwise might be quite profound swings in prices.” Airlines such as Delta have sought to address those risks by getting into the petroleum refining business “Having a refinery helps them smooth out what otherwise might be some potentially very dramatic wrinkles.”

On the other hand, rising oil prices will of course bring cheer to producers in the U.S., notably those in Texas. Mason noted that those prices have driven “robust drilling efforts” in the Bakken Formation (in Montana and North Dakota), northern Colorado and eastern Wyoming. “As we go forward, you’ll see very strong production coming out of the U.S.”

Disputes around laying of oil pipelines have for long dampened the spirits of oil producers, but now, “there seems to be real strong interest in an expanding pipeline infrastructure in Texas,” said Mason. “It was so much worse in 2014,” he said; back then, oil prices were at high levels approaching $105 a barrel.

Pirrong expected bottlenecks cropping up, especially in the Permian Basin in Texas, noting that pipeline construction hasn’t kept pace with oil production increases.

Shaky Production Agreements

Efforts by the world’s major oil producing countries to prevent a supply glut – with the consequent fall in prices — appear to be coming apart at the seams. Last December, OPEC and a Russia-led group of oil producers agreed on production cuts. But barely a month later, Russia complained that it cannot cut production at short notice, and departures from the December agreement seem likelier than they did earlier. While production cuts help boost overall oil prices, individual countries are tempted to produce more while prices are high – hence the violations to agreements. In the December agreement, OPEC granted exemptions to Iran, Libya and Venezuela because of economic strife in their countries.

In fact, supplies from Iran, Libya and Venezuela are bigger threats to oil price stability than cracks in the OPEC-Russia cartel, according to Mason. “These two countries (Saudi Arabia and Russia) have been flirting with arrangements for many months,” he said. “Sometimes they seem to strike a deal. Oftentimes the deal is shallow and a little bit like a paper bag. A perhaps larger concern would be impacts on global crude markets because other producers – Libya, Venezuela and Iran – are always lurking in the background. I think those are probably larger deals than whatever posturing comes out of Riyadh and Moscow.”

Pirrong noted that Russia has always been a somewhat reluctant participant in the production agreement. “The level of prices right now is much to their liking and some of the people in the Russian oil industry – for example, the head of Rosneft, Igor Sechin — have always been champing at the bit to increase output,” he said. “And so, the fate of the deal is somewhat tenuous right now.” He agreed that other factors like output from Iran, Libya and Venezuela “are probably going to be of more importance in the next several months.”

“The level of prices right now is much to their liking and some of the people in the Russian oil industry … have always been champing at the bit to increase output.” –Craig Pirrong

More Actors on Stage

Iran has been “trying to sell its oil desperately and nobody wants to buy, given the [U.S.] sanctions situation,” Pirrong said, citing a Wall Street Journal report. “They’re having to resort to all sorts of subterfuge to try to get oil out onto the world markets.” Big international customers of Iranian oil like China and India, which won limited-period exemptions from U.S. sanctions, “are a little bit harder for us to exert pressure on,” said Mason. He expected the two countries to continue to find ways around sanctions to keep buying Iranian oil. Oil exports from Venezuela are likely to have a limited impact on global supply because they are mostly sent to China to offset debt, said Mason.

However, oil demand from China could perk up as it attempts to lift itself out of its current economic slowdown with an investment-led growth stimulus and tax cuts. “China’s attempts to use the stimulus approach to rejuvenate growth are always bullish for commodity demand, including oil demand,” said Pirrong. Added Mason: “The projections I’ve seen put conjectured growth rates for China in the range of 5% or 6% annually, and that swamps everything in the West.” At the same time, both Pirrong and Mason were skeptical of China’s official growth statistics.

The sanctions against Iran and against Venezuela have “affected expectations and anticipations of what’s going to happen going forward – not so much [oil] production,” said Mason. “Those expectations can play a really important role – expectations among buyers, refiners, big international crude oil producing companies … the whole enchilada.”

Amid those crosscurrents, Saudi Arabia has for decades been the “swing factor” in the oil markets, Pirrong noted. “They have borne the brunt of the production cuts and they look to be continuing that going forward. They’ve been the leader in these output cuts and have been very aggressive in meeting their commitments.” Saudi Arabia has also been pressuring the Trump administration to not renew the waivers for Iranian crude imports that the U.S. government has granted to various countries, he added.

“You have these big, traumatic interactions between major producers outside of the U.S. – Russia, Iran and Saudi Arabia – and it makes for interesting drama.” –Charles Mason

Decline of the Old Order

Along with the changes in the supply-demand equation within the global oil industry, the power of some of yesteryear’s major forces is also fading.  For instance, according to Pirrong, Saudi Arabia’s role as a swing producer of oil is “in the bell lap” as predictions are for the Permian Basin to outproduce Saudi Arabia within the decade.

“[The world oil] market is becoming more fluid and more competitive, in large measure because of the emerging role of major production basins in the U.S., particularly the Permian Basin,” said Mason. “As that becomes more important globally, the role of large producing countries will wane and their historic impact on crude markets will become something of a historical relic.” Pirrong agreed and also forecast that OPEC’s influence will also “wax and wane” in the future, noting that it faces internal tensions and conflicts of interest.

Mason also predicted a declining importance of traditional geopolitical postures in the oil markets in time to come. “You have these big, traumatic interactions between major producers outside of the U.S. – Russia, Iran and Saudi Arabia – and it makes for interesting drama,” he said. “Enjoy it while you can, because the chances of that really impacting international markets going forward are going to become slimmer and slimmer.”

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