OK, so maybe my caution on oil prices last week was a little misplaced.
After suggesting in Money Morning that this might not be the bottom for oil prices, the price has promptly surged at unheard-of speed.
According to the FT this morning, “oil prices have rocketed more than 25% in three trading sessions”.
That’s pretty incredible. Prices have slipped back this morning – as you’d perhaps expect after that sort of surge – but what was behind the spike? And can it continue?
Oil’s rollercoaster ride
I’m not sure the volatility in oil prices this week says much about the fundamentals. It says a lot more about the psychology of markets than anything else.
There are a lot of people with itchy trigger fingers out there. On the one hand, there’s a host of people who are still mentally ‘anchored’ to the idea that oil prices should be somewhere around the $70 a barrel mark, if not higher. They’re ready to buy on a sniff of news.
On the other hand, a lot of people have made a lot of money from oil prices falling. Some of them are nervy about losing that money. Others are wedded to the ‘short oil’ trade.
It doesn’t take much movement – down or up – to get either side excited or panicky. And in these ‘thin’ summer markets that we’re always hearing about, it’s even easier than usual.
Story-wise, there were two factors that saw oil prices spike yesterday. One was a report from the EIA (Energy Information Administration) in the US. That pointed to US shale producers cutting back production more rapidly than expected. US crude production has plateaued, it seems.
The other was a piece in ‘Opec Bulletin’, Opec’s in-house magazine. Somewhere between the sudoku and the knitting pattern (I jest, it was the lead), was an article headlined “Co-operation holds the key to oil’s future”.
Now, I have to admit, having read this piece – and to be fair, I’m not a regular subscriber to Opec Bulletin, riveting as it is, so I might have missed some nuance – I couldn’t work out what the fuss is about.
The piece argues that demand for oil will pick up. It also vaguely hints that Opec is “ready to talk to all other producers… Co-operation is and will always remain the key to oil’s future”.
One broker in the FT suggests that this is the first sign of the cartel giving up, and perhaps preparing to discuss ways to put a floor under the price with other big oil producers – such as Russia, maybe. But it strikes me as a stretch.
Why Opec is pumping oil for all it’s worth
In any case, it’s worth remembering why the oil cartel is pumping oil so hard just now. Yes, Saudi Arabia doesn’t want to lose share to various internal rivals, which is one reason. But fundamentally, it’s because Opec is facing a new rival in the form of the US.
You’ve got a situation where US production is adding to global supply, whether Opec pumps or not. At some point, that was always going to drive down prices. There’s also the threat – which bothers Saudi Arabia more – that the US would start exporting crude oil. Given the choice, the US could easily win a lot of business as a reliable supplier.
That leaves the cartel with a nasty dilemma. You have a new rival which is driving down prices by increasing supply, and which is also in a great position to steal market share from you. That really only leaves you with one sensible option – try to put them out of business.
That’s the path Opec has been following. Pump as much oil as possible and put those US producers out of business.
Trouble is, prices have crashed, but the US fracking industry has turned out to be more durable than expected.
So what happens now?
Oil traders are waiting for Opec to squeal in pain and give up. And I’m sure that a headline declaring “Saudis slash oil output” would send prices rebounding.
But the problem is that in the medium term, that would just put them all back to square one. Anything that pushes oil prices higher is good for US producers too. And because fracking technology is improving, and thus getting cheaper and easier all the time, the price at which it becomes worthwhile for US producers to expand is falling all the time.
In other words, quitting now would be a sign of desperation, not a sign to go out and buy oil again. In short, to me this looks like a combination of wishful thinking, over-excitable markets, and traders drunk on wild price swings. I wouldn’t bet on this rebound being sustained.
We’ll have more on the state of the oil market in the next issue of MoneyWeek magazine out on Friday.
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