Oil Supply Rising

March 16, 2010

With higher rig counts and increasing OPEC production, is crude headed for oversupply?
  • Why quotas matter when prices are low, not high
  • How do rig counts affect the price of oil?
  • Why has the futures curve flattened?


Although oil closed down yesterday at $79.80—the lowest it's been at in two weeks—prices are still much higher than this time last year, back when oil was sitting around $55 a barrel. And that makes OPEC, for one, much happier.


OPEC's Failure To Hit Quotas

OPEC nations currently supply roughly a third of the world's oil: Data from the Energy Information Administration puts total global oil production for February at 85.77 million barrels/day, with OPEC contributing 29.49 million barrels' worth. This, of course, gives them remarkable power over the fate of crude oil.

But as our favorite dysfunctional monopoly gets ready to meet on Wednesday to decide the fate of the world—or at least the price of crude—there's a surprising lack of hoopla surrounding the meeting. Most analysts and commentators seem to think that OPEC will leave the current production quota of 24.845 million barrels per day intact. In Business Week, Harry Tchilinguirian, head of commodity derivatives research at BNP Paribas SA in London is quoted as saying:


"We think you would need to see prices go to $65 before you spur concern within the cartel. It is easier to turn a blind eye rather than go through negotiations over new quota allocations."


The blind eye Tchilinguirian refers to is the countries in excess of their production quotas. After all, with prices hovering near $80 and an economic recovery steadily gaining steam, things are looking pretty good for OPEC. Besides, ignoring overproduction has worked well so far for member states. OPEC's own monthly report puts production at 26.811 million barrels a day (not counting Iraq, which is exempt from the quota system), which is 1.966 million barrels per day over quota—a number which may get even higher.

Here's the thing—OPEC's power truly surges when oil prices are low, not high. When they are comparatively low, constraining supply has the real power to increase prices. Low oil prices give OPEC members the incentive to work together and comply with the set quotas, as countries need higher gas prices to meet their annual budgets. But that incentive to work together crumbles as oil prices rise and it becomes more profitable to pump over quota. As the Financial Times states, "Compliance has slipped to about 53 per cent from more than 80 per cent a year ago."

If half the OPEC countries are pumping over quota, then you can probably expect a lot of backroom arm twisting at the meeting tomorrow.


Rig Counts

One way to increase crude production is through exploration and development of new oil fields—something that OPEC members have apparently started taking an interest in again.

According to a recent Bloomberg report, OPEC nations have increased crude drilling at the fastest rate in 2 1/2 years: In January and February alone, OPEC countries added 22 rigs—an 8 percent increase to a total of 283 active rigs (the blue line on the chart below):


Rig Counts


And while non-OPEC countries also added 22 rigs, that brought the total number of rigs operating outside of OPEC to 785, only a 2.9 percent increase (the red line on the chart above). These new rigs are mainly used for exploring and developing new fields, rather than for maintenance or work-over activities, according to Baker Hughes.


As with natural gas [March Madness In Natural Gas], oil rig counts can give you some information about future supply coming online—although, as you can see above, they're not a perfect predictor of future prices. New non-OPEC rigs increased as oil prices rose in 2008, only to fall off dramatically as oil prices fell, while the number of OPEC rigs remained somewhat steadier over 2008, with 2009 witnessing decreasing rig counts.

That's what makes this latest jump in rig counts so unusual: More rigs mean more supply—but where will that supply go?


Where's The Demand?

Certainly not to developed markets. Even without any new policy mandates or increased alternative energy usage, demand stateside is forecasted to drop each year by 0.7 percent until 2030, according to the International Energy Agency. In European countries, demand is expected to drop 0.4 percent each year.

Instead, it's our good friend China where the IEA expects to see the most demand growth, to the tune of 3.3 percent per year.

Still, as a whole, the market seems a lot less concerned with supply right now. Compare today's futures curve with what we saw in mid-December last year:


WTI Curve


Clearly the current futures curve has flattened quite a bit, indicating that contango has eased off; the market is getting comfortable with the idea of how much future supply will be available. (Remember: Contango occurs when a futures contract is more expensive in the future than it is today.)

A flatter futures curve could have an interesting effect on supply. During steep contango, you can make money by purchasing oil now, storing it and selling your futures contracts on the oil six or eight months out, locking in guaranteed profit, provided you can recoup your storage costs (and you have a spare oil tanker moored somewhere). But when the contango lessens, the oil stored in this manner could start to flow out of storage and back into the market, as the profit margin for storing that oil narrows. The result? Even more supply on the market.

While I'm not saying oil prices are going to tank anytime in the near future, the supply/demand picture does suggest things may end up being a little less volatile for a while—as long as no one does anything rash.


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