The U.S. still holds the oil price wildcard

There’s a lot of enthusiasm for oil prices these days, and why not? West Texas intermediate crude (WTI) has soared by more than 20 per cent since mid-June, and it seems to have settled in at the US$50-plus range. WTI’s global benchmark counterpart, Brent, has been edging near US$60 a barrel, its highest mark in two years. Canadian energy stocks are responding in kind: the S&P/TSX capped energy index is up more than 14 per cent in the past 30 days.

This is approaching bull territory, folks, and energy investors must be breathing a sigh of relief, or getting downright excited, by the prospect of a long and sustained recovery.

But, there’s a but – a few of them, actually. If we’re expecting a bull run in oil prices that’s anything like the nearly-decade-long rally in the broader stock market, we could very well end up disappointed.

Granted, there are several tailwinds for oil prices right now. The semi-autonomous region of Kurdistan voted this week for independence, ticking off Iraq (of which it is a part) and its neighbour Turkey. Turkish Prime Minister Recep Erdogan has threatened to block Kurdish oil exports through his country; Iraq has called for an international boycott. Those moves threaten Kurdistan’s 600,000-barrel-a-day output, and armed conflict, one supposes, is a possibility. Brent crude has surged in response.


Yet there’s little reason to think the confrontation will escalate that much, and it might not last very long. Iraq has long opposed Kurdish oil exports, to little effect, and Turkey has a stake in Kurdish oil, namely fat royalties. The United States, meanwhile, also opposes Kurdistan’s move as unnecessarily destabilizing, and may pressure for a peaceful resolution.

Among the other tailwinds for oil, U.S. crude reserves have fallen, according to data released Wednesday by the Energy Information Administration. Yet that might be a one-time pickup, as it comes in response to U.S. refineries resuming operations as they recover from Hurricane Harvey. More compelling as a boost is the surging market in diesel, which suggests that a stronger economic growth is underpinning prices; reconstruction in the U.S. after extensive hurricane damage will likely add to demand, but again, that could prove short-lived beyond the first quarter of next year.

Perhaps the strongest tailwind for oil prices, however, will come from an unlikely source: the U.S. Federal Reserve. If it (along with the Bank of Canada) continues on its tightening path, North American shale producers’ cost of borrowing could rise dramatically, and higher rates could serve to push marginal producers out of the market. To the extent they might put a cap on U.S. supply, rising interest rates could support a further rise in prices.

But that’s hardly assured. Let’s not forget that, for all the speech Fed officials have been giving lately, the path of further rate hikes is not written in stone; weak inflation numbers, for one thing, continue to undermine its justification for rate normalization. More important, maybe, is the fact that shale producers have proven time and again that they are remarkably resilient in the face of adverse market conditions.


It might be that higher rates will put pressure on marginal producers, but U.S. producers have been busy exploiting the export market. With Brent priced so much higher than WTI, American crude has become more price-competitive, and exports have surged. According to EIA data, U.S. exports in the third week of September hit 1.5 million barrels — a record — and overall exports have been on average more than 60 per cent higher than last year. Broadening their export markets could help U.S. producers withstand the shock of higher rates.

Anecdotal evidence also suggests that U.S. producers have also started hedging, effectively locking in current (high) market prices. That will support further supply coming online, which could happen in the next six to nine months. According to oilfield services firm Baker Hughes, the U.S. rig count has been falling through September, but don’t expect that to last in the face of the recent price surge.

The U.S. oil industry might account for less than 10 per cent of global supply, but it remains, arguably, the single most important wildcard when it comes to crude prices. It has proven itself innovative, resilient and able to inject incredible supply elasticity in response to price fluctuations. Can anyone really see that ending anytime soon? Saudi Arabia, which theoretically can turn a buck with US$10-a-barrel crude, might be able to pull it off, if it were to open the taps and return to the strategy of former oil minister Ali Al-Naimi. But there’s no indication the Saudis have the stomach for that.

Put it all together, and it’s hard to see crude prices remaining sustainably higher for longer, because it’s hard to see them breaking out of a now familiar pattern in the post-OPEC world: Price goes up. Supply goes up. Price comes down.

Rinse and repeat.

Financial Post

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