The wavering status of the oil risk premium | The Triangle

The wavering status of the oil risk premium

Wikimedia: John Messina
Wikimedia: John Messina

Oil prices for Brent and West Texas Intermediate (WTI) dropped to about $26.65 a barrel in February due to a surplus caused by the accelerated production of oil shale and Saudi Arabia’s new policy of maximizing market share. There were forecasts that predicted that prices would fall to $20 and stay there. Instead, prices made a U-turn and surged, reaching $50 a barrel at the end of May this year.  It was predicted that it would reach $50 a barrel in the middle of 2017 when the current 1.4 million barrel a day (mbd) surplus is eliminated and the global oil supply and demand balances. Instead, there are now sweeping forecasts that oil prices will reach $70 a barrel.

Currently, oil prices are not respecting the long-run fundamentals or the confluence of incidental factors that have trumped global market supply and demand. There is a supply disruption that is equal to about 3.5 mbd of OPEC and non OPEC oil due to outages, which is the highest since the 2003 US-Iraq war. Among those outages is the production cut that resulted from the fire that wreaked havoc on the Canadian oil sand-producing units in Alberta. This distribution took about a million barrels a day of Canada’s oil production, which is largely exported to the oil storage tanks in Cushing, Oklahoma. This led to a decline in onshore oil storage in the United States, which was confused by oil traders as an increase in demand and helped drive up oil prices to $50.

Another incidental factor is the disruption of oil facilities in the Niger Delta of Nigeria by the Delta Niger Avengers (NDA), which reduced Nigeria’s oil production from 2.2 mbd to 1.1 mbd. This disruption will stay longer than the cut in Canada’s oil by the Alberta fire, as NDA is now threatening to launch more severe attacks in the Niger Delta.

The more credible factor of the current surge in oil prices is the drop of shale oil in the United States. The drop has been about 900,000 mbd since 2015 and is now accelerating. But this factor is still misunderstood because of lack of sufficient knowledge about the drilled but not completed oil wells (DUCS). There are about 5,000 DUCS in the United States which may come on stream if oil prices exceed $50 a barrel. On the other hand, there has been a significant cut in Capex by exploration and production companies, which may take some time to make up for the ongoing depletion in existing wells.

There is also political instability in other OPEC countries such as Venezuela, which has the highest proven reserves in the world and Iraq, which possesses the third largest global reserves. In addition, there is no end in sight for Libya, which has been witnessing domestic wars run by proxies of foreign countries.

These factors have brought the geopolitical risk premium back to oil prices and swayed them from the fundamentals. This risk premium had disappeared post June 2014 when the oil market started to develop a large surplus that was sufficiently large enough to make up for any potential disruption. This premium accounts for a good portion of the $50. Risk premiums do not reflect the fundamentals and may disappear quickly once most of the incidental factors vanish, particularly if Saudi Arabia follows through on its threat of increasing its production from 10.2 mbd to 12 mbd.  It is likely that oil prices will not reach $70 a barrel in 2017 and $100 by 2020 once the supply and demand start to rebalance and the risk premium fades.