The Strategist

Why OPEC failed to spur oil prices

03/17/2017 - 15:19

Current situation on the oil market bears certain similarity of a scene from "The Big Short" - a well-known film about financial speculation. Two men protagonists fly over oil reservoirs and take photographs with an infrared camera, trying to estimate level of reserves in 2,100 reservoirs across America and find out how overvalued the oil is.

In fact, everything is much simpler. The data collection specialists work for Genscape, which sells information to traders around the world, providing an advantage in a few days before the government publishes an official report. This information is particularly useful when record stocks in the US are putting serious pressure on the cost of oil and interfering with OPEC's attempts to support the market.

According to the International Energy Agency, a high level of reserves is extremely important for understanding reasons for a sudden collapse of prices this month. Recently, quotes of BT broke through $ 50 per barrel - the level last seen in November before the oil producers agreed to cut production.

Record volumes of stocks are explained by three reasons:

1. Appetites of hedge funds

 The OPEC agreement with countries outside the cartel (like Russia) on limitation of production since January 1 led to large-scale purchases from hedge funds’ side. Consequently, this triggered price increases.

American slate producers hurried to take advantage of favorable conditions by increasing production. Number of active drilling rigs in the US rose to 617 from 386 a year earlier, and oil production jumped by 400 thousand barrels a day from the September lows. The bulk of it went to oil storage facilities, such as Cushing, Oklahoma. 

2. OPEC has become a hostage of its own actions

Shortly before the agreement entered into force, the cartel sharply increased production and exports. Within a few months, all this oil crossed the Atlantic and began to enter the terminals. This inflow has pended further refining at the refineries, which resumed operation after maintenance.

3. Curve of futures prices

The third factor is futures’ price curve, which is closely related to the level of stocks. By organizing a reduction in production in January, OPEC hoped to balance supply and demand by the middle of the year and push the futures market to backwardation - a situation where prices are lower in the future than in the present. The backwardation reflects readiness of the market to buy and process oil, rather than store it. The strategy worked for a while. Yet, once the US published the data on oil reserves on March 8, the market returned to contango - in this case, future prices are higher than these. It is beneficial to buy oil for storage when the market is being in the contango state. Hillary Stevenson from Genscape notes that cost of storing one barrel of oil in Cushing's oil storages is $ 0.41 per month, while contango of futures expiring in a month exceeds $ 0.65.

Contango acts as a negative feedback, since the more oil the terminals store, the lower the short-term prices become. Thus, OPEC is trying to break this connection, perhaps by promising to prolong production cuts for the second half of the year. In this case, however, slate producers will certainly expand their activities, and the confrontation will flare up with renewed vigor.