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Oil markets are cyclical — eventually they will rebalance

This was an eventful week for oil markets. The great and good of the industry congregated at the 22nd World Petroleum Congress (WPC). The discussion was about the general state of the oil industry, electric vehicles, renewables, and when oil markets will finally balance. 

The monthly oil reports from the Organization of the Petroleum Exporting Countries (OPEC) and the International Energy Agency (IEA) were published. They threw a spanner in the works of optimists who hoped for higher oil prices. The commodity has slid 17 percent since the beginning of the year.

In December, OPEC and 10 non-OPEC countries agreed to cut production by a combined 1.8 million barrels per day (bpd). OPEC compliance was high, exceeding 100 percent at times. The IEA report said compliance had fallen to 78 percent in June, mainly due to unexpected increases in production by Nigeria and Libya. Both countries were exempted from the production cuts, reflecting their difficult internal political situations. 

Over the last few months, they increased production by a combined 700,000 bpd, according to OPEC and the IEA. On the back-end of these reports, markets failed to react positively to a larger-than-expected 7.7 million barrel draw in US crude stocks. The price for Brent stood at slightly above $48 in Thursday midday trading.

What is new is that market participants seem no longer to be solely preoccupied by the increase in US shale production and US crude inventories, but increasingly worry about higher production from Nigeria and Libya. 

Black swans

The Nigerian and Libyan production increases exceeded all expectations. This will be discussed at the Joint Ministerial Monitoring Committee (JMMC) overseeing the deal later this month in Moscow. The magnitude of production increases came as a surprise, but there is an element of unpredictability as to how they will be sustained, especially in Libya, where the political and security situations are fluid.

There are other surprises indicating higher production, such as the projected increase in Canadian production by 590,000 bpd in 2017/18. There are bound to be more unforeseen developments in other parts of the world. There may also be surprises indicating lower production. For instance, it is difficult to have visibility of political developments in Venezuela and how this will impact oil production over the next few months.

Balancing any market has two sides to the equation: Supply and demand. The demand picture looks positive. Different sources predict increases of about 1.2-1.5 million bpd for both 2017 and 2018. The economies of Europe, the US, China and India are humming, which is always good for demand. 

There was a lot of talk of switching to electric vehicles at the WPC. This may be, but this is a longer-term phenomenon because it requires a substantial infrastructure build. The emerging middle classes in China and India expect to purchase and drive cars now. These vehicles will be gasoline-powered. The IEA has furthermore pointed out that the electronic-vehicle revolution has so far not reached the freight market, which is substantial.

In the medium term, we should probably look at the impact of investment cutbacks over the last few years. International oil companies cancelled billions of dollars of planned investments due to persistently low oil prices. This is a problem because oil fields have a limited lifespan and conventional oil is an ultra-long-cycle business. 

Balancing any market has two sides to the equation: Supply and demand. The demand picture looks positive.

Cornelia Meyer

A dollar invested in conventional oil today will result in production three, or more likely seven to 10 years from now. Sooner or later this lack of investment will start to bite. Assuming projected demand patterns, we may see shortages down the road. As we are dealing with long lead times, producers will not be able to just turn on the tap.

Cyclical markets

All of the above shows that oil markets are cyclical. They have always been, and will always be. OPEC plays the long game. It has to if it wants to fulfil its mandate and ensure markets are adequately supplied. 

There are now also more non-OPEC players than before, both in the conventional and non-conventional (shale / tight oil) space. This is the context in which OPEC’s secretary-general said in Istanbul that all producers had to cooperate to get markets into balance.

BP CEO Bob Dudley told CNBC recently that the market was in balance on a daily basis, but the huge inventory overhang was looming large. He may have had a point, but markets are inherently psychological and short-term. At this point, their mindset is to look at supply rather than demand, which is why they react so sharply to any incremental production rise.

• Cornelia Meyer is a business consultant, macroeconomist and energy expert. She can be reached on Twitter @MeyerResources.