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A Ceiling on the Recent Oil Price Run Up

Oil glut moved to gasoline or stored in tankers

Oil has been steadily rising the last few weeks, with the Canadian dollar strengthening in tandem. Market talking heads have been calling a return to $65 or $70 oil as OPEC effectively “rebalances” the market with cuts, theoretically a smart way to capture more money from oil buyers while existing production depletes and older wells stop pumping.

This theory should be approached cautiously as there are a lot of factors that work against this cutting, consistent with our discussions in past posts where cutting is not necessarily effective in a world where the supply balance is no longer dominated by OPEC. Here are some additional major factors that could impose ceilings on the oil price.

OPEC Cheaters and the Saudi Aramco IPO

All of OPEC wants the oil price to be high – however major producers in the cartel and unofficial members of the cartel, such as Iraq and Russia, respectively, have been known to produce more than what they have pledged to produce (every incremental barrel is money in government coffers, especially important for Iraq as they have spent a large amount of money fighting ISIS). This recent edition of OPEC cuts has been no different, however Saudi Arabia has been quietly taking on most of the cuts. A logical next question to ask is why?

Saudi Arabia is looking to monetize their oil reserves through an IPO of their energy operations (including pipelines and refineries – whether that includes their physical reserves or just proceeds from them is unclear at this point). This IPO includes many of the world’s largest investment banks, causing them to have a vested interest as well in speaking to oil price upside. The higher the oil price, the higher the value of the firm as the present value of future cash flows will rise.

Saudi Arabia is in turn looking to use these proceeds for technology and infrastructure investments, as deals with Blackstone, Softbank and the Trump Administration have been struck. Once the company floats (somewhat dependent on secondary equity issues), there is then an incentive to pump as much as they can before the oil age ends.

Hedging by Shale Oil Producers

Crude oil is the most important commodity in the world and the largest by traded dollar volume. There is an extensive derivatives market for oil and oil products – should the market expect oil prices to rise, oil forwards and futures will allow producers to lock in hedges (an oil producer that produces 100,000 barrels per day may hedge in their production for $65 dollars a barrel when the cost of production is far lower), ensuring their economics and allowing them to continue to expand drilling operations indefinitely. This will put pressure on prices as supply will continue to flood the market.

Trump and the Strategic Petroleum Reserve

Today was a big day for oil news, with Trump pondering the sale of half of the US’s Strategic Petroleum Reserve to fund tax cuts and spending, signalling his confidence and vested interest in continuously rising oil and gas production in the USA. Should the USA follow through with this, this is a clear negative for the oil price. This follows the need to monetize oil today while sovereigns are still able to rather than having dead money in the ground when renewables take over as the primary fuel source.

Oil Glut Moving Downstream

Although upwards oil price movements have been explained by larger than expected inventory draws, the oil is being sent further downstream in the value chain and converted into gasoline but not being consumed from there. Oil inventories fall but gasoline inventories rise, and this gasoline does not necessarily go into cars. If gasoline stockpiles rise too much, the bottleneck reappears. A lot of refineries are locking in gains using storage or derivatives in anticipation of the summer driving season, but if summer fails to deplete the gasoline glut, there are more negative ramifications for oil.

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