Why Oil Prices Are Going to Stay Put for a While

February 23, 2016, 7:37 PM UTC
The 168th Organization Of Petroleum Exporting Countries (OPEC) Conference
Bloomberg via Getty Images

Freezing oil production simply won’t cut it. For the oil markets to begin moving to the upside anytime soon, Saudi Arabia and the other major oil producers need to cut production. Without such a cut, expect oil prices to remain relatively weak for some time.

Saudi Arabia’s oil minister, Ali Al-Naimi, told a packed audience of energy executives at the annual IHS Cera conference in Houston on Tuesday morning that his country was no longer willing to curb its production or facilitate a round of production cuts with other oil exporters to stabilize energy prices.

Instead, Naimi said that Saudi Arabia would be willing to freeze oil production at current levels, but only if enough countries agreed to join in. Last week, Naimi met with Russia’s energy minister, Alexander Novak, to discuss a potential freeze, but nothing was agreed to at that meeting. Naimi said on Tuesday that he plans on meeting with other nations in March to discuss the situation, but he made no promises that a freeze was in the cards.

News that cuts were off the table sent oil prices plummeting on Tuesday morning, with the WTI falling nearly 5% to $31.75 a barrel. While the market didn’t think that the Saudis were going to unilaterally cut their own production, there was hope that the oil giant would eventually break down and work with fellow oil producers to negotiate a coordinated cut of some sort.

“Freezing now at the January level is adequate for the market, we believe,” Al-Naimi told reporters in Doha last week. “It is the beginning of a process, which we will assess in the next few months and decide if we need other steps to stabilize and improve the market.”

Even if Naimi is able to secure an oil production freeze with Russia, it won’t do much to stabilize the markets. It turns out that production levels this past winter in both countries were high—very high. In Russia, oil production rose to 10.989 million barrels a day in January, the highest production level ever recorded for the country in the post-Soviet era. Saudi Arabia, meanwhile, produced 9.96 million barrels a day, which, while down from its peak of 10.25 million barrels a day, is still 350,000 barrels a day higher than what it was during the same month last year.

Freezing production at what appears to be record and near-record highs for both countries seems, well, unimpressive. The only positive thing here for oil bulls is that Saudi Arabia won’t be turning its oil spigots to full blast. The country could produce an extra 2.5 million barrels of oil per day if it wanted to. But it rarely, if ever, produces at full blast, and no one really expects them to do that now, or ever. Saudi Arabia is expected to produce an average of 10 million barrels a day this year, roughly equal to what the country produced in January.

So, what will it take for oil prices to move back up?

Last year, the world produced, on average, around 1.8 million barrels of oil per day in excess of global demand. Those extra barrels went into storage tanks, adding to the glut in oil stockpiles across the globe, particularly in North America. There is currently around three billion barrels of oil in commercial storage tanks across the world, according to the International Energy Agency, a record. That is equal to around a full month of global oil consumption (which is a lot). So for prices to rise, the market needs to not only knock out the overhang in production, it also needs to eat away at all the oil in storage tanks as well.

Demand for oil is still growing. Despite a tepid economic outlook, oil demand is expected to increase by an average of around 1.6 million barrels per day in 2016, according to the Energy Information Agency. If that holds true, and production remains frozen at last year’s average levels, the market will still be overproducing at a rate of around 200,000 barrels a day. But weak oil prices should cause high-cost oil production, especially in the United States, to decline this year. The EIA expects that weak prices should cause non-OPEC oil production to fall by around 600,000 barrels a day in 2016. This implies a global oil shortfall of around 400,000 barrels a day.

But this doesn’t take into account the potential increase in OPEC oil production coming from Iraq and Iran. Unlike the rest of OPEC, Iraq is not subject to production quotas, as it continues to rebuild its oil infrastructure following two decades of sanctions, war, and civil unrest. Iraq, which is already OPEC’s second-largest oil producer at 3.6 million barrels a day, plans to increase its oil production by a whopping 400,000 barrels per day in 2016, to just over four million barrels per day. It has plans to reach 7.5 million barrels a day within the next five years, so it’s doubtful that it would be willing to curb its production at a measly 3.6 million barrels a day.

Meanwhile, Iran, which just loaded its first oil cargo bound for Europe in four years, is expected to pump an extra 300,000 barrels of oil per day this year compared to last year, for a total of 3.1 million barrels a day, according to the Energy Information Agency. Iran’s oil minister, Bijan Zanganeh, told reporters last week that he “welcomes” talk of a freeze but he stopped short of saying whether the Islamic Republic would be willing to freeze its own production at January levels.

Both Iran and Iraq will continue to increase production, regardless of oil prices, as any profit is better than no profit. Iraq is currently engaged in an expensive war with Isis while Iran needs as much money as it can get to continue its various paramilitary activities in the region.

So if you add the extra production expected from Iran (300,000 barrels a day) and Iraq (400,000 barrels a day), that cancels out the expected decline in U.S. and non-OPEC production. The world would still be producing a net 300,000 barrels per day more than what it needs.

Russia and Saudi Arabia need to do more than just freeze production. They need to cut it. If both nations agree to a 5% cut, world oil output would decline by around one million barrels a day. That would wipe away the overhang in production, leading to a global production shortfall of around 700,000 barrels per day.

It is simply unreasonable to expect Iraq or Iran to freeze, let alone cut, production in kind. Russia and Saudi Arabia have the power to get oil prices under control. It just depends on how badly they want it.