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Energy and geopolitics have always been closely intertwined. No more is that so that with the oil price which hovers around $70 a barrel, its highest level in 4 years. It is also there because of increasing geopolitical risk around Venezuelan prodction and growing tensions in the Middle East. However, these risks will clear and as they do oil prices will fall thanks to huge production increases by US shale oil producers, as the reality is that we are living in the era of abundant and cheap energy.
Venezuela has been one of the major reasons why global oil inventory levels have fallen in recent quarters. They are currently producing 1.4m barrels per day, which is 50% below peak production, and in fact are pumping 550,000 fewer barrels per day than they are allowed under the most recent OPEC production targets agreement. All of this is because of bad management particularly within the national oil company, PDVSA, which has come under economic considerable pressure, due to sanctions from the US as well as the low oil prices, is currently unable to secure necessary financing following the missing of a number of debt repayments to keys suppliers as well as having lost a $2bn lawsuit against the US oil company ConocoPhillips for having falsely expropriated some of their oil assets. How this situation will sort itself out is not clear but what is sure is that oil exports are so important for the already fragile Venezuelan economy that the government has to find a solution, and quickly.
The Middle East situation, on the other hand, is a risk to future oil supply. It is all about the rivalry between Iran on the one side and the unlikely partnership of Saudi Arabia and Israel (with US support) on the other side; a rivalry that has its battle front in countries throughout the region, such as Lebanon, Libya, Yemen and Iraq. There is of course the possibility that the rivalry between the Saudi Arabia and Iran goes beyond a proxy war to a full blown conflict which would in turn have a drastic impact on the oil price. However, this is highly unlikely as such a conflict would likely face huge resistance at home which in turn could lead to a regime change in these countries. In addition, Saudi Arabia would find it very difficult to take control of Iran, given the mighty Zagros Mountains which separate the country from Iraq. And from the Iranian side, they don’t control the land needed to supply any war effort against Saudi and any war is likely to split Iraq which lies between the two countries. What we are thus more likely to see is more of the same with both countries pushing against each other but not enough to have a full blown conflict.
Then we have the OPEC meeting on the 22nd of this month which could be very interesting especially with US sanctions against Iran having been announced but not supported by Europe or China. Iran may react by either cheating on the agreed OPEC production quota or just leave the deal, which of course would weigh on oil prices, especially if other countries like Russia follow suit. We are also seeing growing pressure on Saudi Arabia to increase production to counterbalance any reductions in Iranian exports. In a nutshell, it could be a very interesting meeting in Vienna with consensus unlikely and even if there is it will likely be bearish for the oil price. But even if this does not happen the likelihood is still that oil prices will fall later in the year because of increases in US shale production.
Over the last years, shale operators have done a very good job of reducing costs of extraction costs by improving their drilling processes and applying digital technologies. In addition, those who have survived the washout caused by the collapse in oil prices are better funded, more flexible and financially stronger than ever before. In addition, the traditional large oil companies are also starting to invest substantially in shale. And the longer oil prices stay at current levels, the more likely it is that shale players can hedge their investments by locking in current oil prices through derivative trades. This gives them even more room to increase production, noting that US oil production levels in March reached record levels of 10.4m barrels per day. In addition, we are also seeing shale drillers go abroad to places like Australia which again will be good for low cost oil production.
At the same time, existing oil well depletion rates which have long being talked off as the reason why oil prices will go back over $100 don’t seem to be panning out. This should not be a surprise given the technological improvements we are seeing around oil exploration and drilling. This is especially the case in Russia where an upgrade in technology is causing oil production to increase rather than decrease as many commentators once predicted.
What does this all mean? I am with oil prices going down during the second half of this year and I think we are many years, if ever, away from $100 oil, unless we see a significant worsening of the Iranian-Saudi relationship, as the reality is we are in the era of abundant and cheap energy.