RCE Q&A: Rapidan's McNally on Oil's Price Fall

RCE Q&A: Rapidan's McNally on Oil's Price Fall

Robert McNally is founder and President of Rapidan Group, an energy market and policy consulting firm in Washington DC. He spoke with RealClearEnergy editor Bill Murray on the consequences of the latest turmoil in global energy markets.

RCE: The fall of oil prices into the $30s a barrel has been targeted by Rapidan and others for some time, but what are people missing in terms of the duration of the current downturn and the reasons for its occurrence?

McNally: The first price collapse late last year was caused by Saudi Arabia’s refusal to unilaterally cut production once some oversupply had developed. The most recent collapse was caused when the market realized shale oil was not going to replace OPEC as a swing supplier. The oil market is global. The US may have the best data transparency, but our supply-demand fundamentals alone do not set global prices. From 2011 to the middle of 2014 visible US data showed a weakening market – a surprising surge in shale production and lethargic demand. But oil prices remained firm around $100. The world market was harder to see, but relatively tight and disrupted.

More recently, the opposite happened: US fundamentals tightened this year in response to lower oil prices – shale is slowing and demand is robust. The spring crude price rally to $60 was driven by the notion that the US would balance the world oil market. But outside the US, a tidal wave of oil was silently building on massive Saudi, Iraqi production increases and resilient production in Russia. Inventories are at record levels and most balances show them building until well into next year. Finally, China’s economic weakness fed into weaker consumption. Like the Led Zeppelin remake went: “If it keeps on raining, levee’s going to break.” It’s breaking.

RCE: The “Verdun thesis,” the idea that both the Saudis and the US tight oil producers are now locked in a major battle that will cost both side immensely is taking hold, but won’t small producers in the US run out of hedges by the end of this year and have to lay down rigs pretty soon, while Saudi Arabia still has $100s of billion in savings to burn through?

McNally: It’s not just Saudis against shale; they actually love shale but just want it to swing. It’s also the Saudis against Iranians, Iraqis, and Russians too; these are producers they do not love and want to beat in the fast-growing Asian market. But yes I agree with the premise of your question, i.e. that Saudi Arabia has more staying power in this fight. They have well over $600bn in foreign exchange reserves and very low debt. The alternative for them is to cut unilaterally, handing market share over to their commercial rivals and in several cases geopolitical adversaries. Whatever Saudi Arabia and other producers thought last year when this got started, they see it now as a much longer contest now. All producers are suffering. But Riyadh will likely persevere until they sweat more cuts from shale producers and compel other OPEC and non-OPEC producers to contribute cuts. It will take longer and lower oil prices.

RCE: Not to stretch the World War One metaphor too far, but does this make the Iranians entering the market in the next year with hundreds of thousands of barrels a day similar to the US entering WWI late and showing up just in time to break the Kaiser’s (Saudis) back?

McNally: I admit the World War One metaphor gets wobbly if only because this time US doughboys showed up early instead of late and helped get the war started! But in terms of a late entrant that could force a decision, yes, I think you’re right about Iran. But if Iran returns and adds a half million or more barrels per day into an already glutted market next year, I’m not sure if it’s the Saudi’s back that gets broken at least first. Russia, Venezuela, US shale producers are ahead of the line for pain, not to mention others like Algeria, Iraq, Nigeria.

RCE: If one makes the assumption that a hard Chinese landing is taking place in 2015, combined with the amount of new crude coming on line this year, how long (what quarter of what year) will it take to get rid of the excess and have some sort of new equilibrium in the price?

McNally: It depends on whether we grind through with economically-driven supply shut-ins and wait for demand to pick up….that’s quarters to possibly years and impossible to predict. But prices could also bottom sooner and more abruptly due to either a producer deal to cut supply such as after the 1986, 1998 or 2008 lows or in the event of a war or convulsion that disrupted oil supply, with Saddam Hussein’s invasion of Kuwait in August 1990 the closest analogue. No sign of that yet, but we’re keeping our eyes open. The Russians and Saudis are starting to talk, which is interesting.

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