Defying great expectations: Dip in oil prices despite supply cuts

By Meghaa Gangahar

Oil also referred to as ‘liquid gold’, is often pegged as a measure of economic (especially industrial) health. After a lull that lasted three long months, the unexpected dip in oil prices has jolted the market yet again. In a bid to stabilise falling prices, OPEC (Organisation of the Petroleum Exporting Countries) decided to cut the supply of oil. But the consequent fall in crude prices was an effect unforeseen by many. In hindsight, the increasing inventories of shale oil in the U.S were the only red flags.

The oil price roller coaster

Thriving since 2012, U.S. shale oil production has not only given the cartel-like monopoly of OPEC some competition but also engaged it in a production and price war that led to the plummet in oil prices. The first cut for OPEC in eight years came towards the end of 2016, when OPEC along with eleven other oil-producing countries, including Russia, announced its decision to cut down crude oil production. The countries decided to curb the global oversupply of oil which had induced an oil glut that had persisted since 2014.

The oil prices, quite diligently, stuck to a rigid price range of $50-55 per barrel for about three months following the announcement by OPEC to cut down production. After weeks of rising oil inventory in the United States, the prices finally crashed through the floor of $50 per barrel on March 8, 2017. By March 10, 2017,  the world benchmark, Brent crude, ended up at $51.37 per barrel, while U.S. West Texas Intermediate crude (WTI) was at $48.49 a barrel. The biggest three-day decline since February 2016 witnessed U.S. crude slump by nearly 9 percent since the close on March 7. This has led to increased expectations of the price staying low, as against those of the rise in price due to a supply shock.

Shale oil stirring up the financial world

The position of oil in financial markets has suddenly been exposed to intense volatility as most expectations in the market were that OPEC production cuts would outweigh the comeback in U.S. shale. This had caused record levels of bullish bets on the oil prices. Options trading had surged with the rise in the shale oil inventories pushing down the price. But now Options contracts that give buyers the right to sell futures at a specific price by a certain date are heavily skewed towards a decline in oil price.

This sentiment is further cemented by the continuous drilling and production expansion of shale oil in North America. The production having skyrocketed to record levels of over 9 million barrels a day, there is an increased rescission in more long positions (buying of a security expected to rise in value).

Although U.S. oil production is surging to fill in the gap left by cutbacks of others, it should be careful not to overflow. As Continental Resources CEO, Harold Hamm, has warned, “The shale drillers should take up a measured approach, else they might ‘kill’ the market.”

Waiting for OPEC’s next move

Even though OPEC and other oil exporting countries agreed to cut back output by about 1.8 million barrels per day, the world oil supply has experienced little variation. With a surprisingly outstanding compliance with the deal within the OPEC, it now faces a big decision-making challenge, of either extending its current plan or rolling it back.

However, some Saudi officials warned U.S. oil companies against the assumption that OPEC would extend output curbs to accommodate shale oil production. If the excessive supply continues and production cuts are not extended, the world could be pushed towards a deeper oil glut. With the next OPEC meeting scheduled for May 25, 2017, all eyes are now turned towards Vienna.