Gold News

$70 High and Rising

The long story behind the soaring oil price...

OIL CARTEL Opec teamed up with Russia to cut production – and managed to stick to the plan, writes John Stepek, editor of MoneyWeek magazine, in the free Money Morning email.

Last week oil (as measured by the US benchmark, WTI) then spiked above $70 a barrel for the first time in more than three years.

The immediate cause of the excitement was the news that Donald Trump was about to announce his decision on withdrawing from the Iran nuclear deal.

New sanctions on Iran will hit global oil supplies and lift prices.

But, as is ever the case with oil, it's about a lot more than the immediate newsflow.

Iran currently produces nearly four million barrels of oil a day. As the FT notes, if sanctions are put back in place, Iranian exports could fall by 200,000 to 300,000 barrels a day.

That's pretty chunky. But really, it's just the tip of the iceberg.

Let's rewind briefly. Oil prices began to crash in 2014 because the Opec oil cartel, led by Saudi Arabia, underestimated the production capacity of US shale oil producers.

The US was rapidly becoming one of the largest oil powers in the world – from a standing start – and yet the rest of the world's producers were blithely continuing on their merry way, confident that they could keep pumping out oil at over $100 a barrel, and it would have no effect on consumer or producer behaviour.

As always, economics forces people to find a way. A combination of substitution effects (you think electric cars would have taken off without $100-a-barrel oil?) and rocketing US production created an oil glut.

That glut was sustained by another Opec miscalculation: Opec assumed it could outlast the shale industry. But while Opec had a low production cost, it had huge bills to pay (Saudi Arabia's balance sheet was hammered – bribing the populace in order to prevent the Arab Spring from spreading was an expensive business).

Shale producers, on the other hand, were able to run at a loss because of the steady flow of cheap credit. Rapidly improving technology brought production costs down and – in the end – enabled them to survive the oil price winter.

Opec gave up first. It teamed up with Russia to cut production. And much to everyone's surprise, a loose union of countries better known for stabbing each other in the back managed to stick to the plan.

Meanwhile, global growth picked up – recovering swiftly from a brief scare in 2015 – and, as a result, supply and demand gradually came back into balance.

Global oil consumption is set to breach 100 million barrels a day for the first time ever this year. Indeed, the International Energy Agency said last month that Opec could pretty much declare "mission accomplished". There is no more glut.

So, let's say – for argument's sake – that supply and demand are back in balance and that demand is steady or rising (for now, global growth remains strong, despite jittery markets).

On the supply side, there are all sorts of signs that things might get tighter.

The Saudis want the oil price to go higher. What the Saudis want, they don't always get, as I mentioned last time I wrote about oil here, but it does mean that they might be willing to maintain current levels of production rather than raise production.

The same probably goes for Russia. Russia's currency is something of an oil-price play and it needs all the help it can get right now, what with sanctions.

On top of this, you have Venezuela. As John Paul Rathbone notes in the FT, Venezuela's oil production has collapsed at a staggering rate. Venezuela used to produce nearly 2.4 million barrels of oil per day. (And when I say "used to", I'm talking a mere three years ago). And this time last year, it was still producing not far off two million barrels a day.

But now, amid an extraordinary economic collapse, Venezuela's daily oil production has slid to just 1.5 million. And analysts are worried that it could fall by a further 500,000 by the end of the year.

This starts to put Iran into perspective. So even without new sanctions being imposed on Iran (which – judging the balance of political probabilities – seems less likely than the alternative, though we'll find out this afternoon), the oil supply is looking at taking a potentially whack.

And that'll only get worse if the US – as is expected – imposes new sanctions after Venezuela's sham elections on 20 May.

Put it like that, and it seems fair to say that the path of least resistance for oil prices remains "up". I'm certainly not suggesting that you should be spread-betting the oil price – chances are it's a bit overcooked at the moment. But in the medium term, I think the bias is certainly higher.

What does it mean? You can stick with your dividend-paying oil stocks. You can continue to bet on the "late-cycle" movers – resources stocks. And none of this will help with inflationary pressures. Companies have been complaining specifically of higher freight rates – that's only going to get worse.

And it'll be interesting to see how higher US inflation, US bond yields, and the return of the almighty Petro-Dollar all interact. Those Dollars raised by selling oil need to be kept somewhere, after all. And US Treasuries have often been the destination of choice. That's a topic for another day though.

Launched alongside the UK's highly popular The Week digest of global and national news in 2001, MoneyWeek magazine mixes a concise reading of the latest financial events with expert comment and investment ideas.

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