His announced retirement alluded to the lack of volatility in the oil market as a reason to shut down his hedge fund, but T. Boone Pickens’ announcement should be taken with an Everest-sized grain of salt, Forbes reports in its article Is Oil Price Volatility A Thing Of The Past?
Granted, at 89 and with a long and storied career behind him, Mr. Pickens could hardly be faulted for wanting to take a well-deserved retirement. He has made major contributions to corporate governance (for good or ill, depending on your point of view), carried out a number of successful oil and gas trades, and worked tirelessly to promote the use of natural gas as a clean alternative to fuels like diesel. But is oil price volatility gone, or just temporarily dampened.
It is certainly true that the past two years have seen oil and gas prices which are much more stable than the historical norm. However, even ignoring the increase of the past few months, there are good reasons to suspect that sharp price movements are likely in the future. First, of course, the reason for the recent lack of stability should be considered.
Probably the primary reason that prices have been range-bound is the perception that the drop in oil prices from $100+ levels seems to have restored the market to a rough equilibrium. Lower oil prices reversed soaring U.S. shale oil production, turning it from an annual increase of 1 million barrels/day or more to a decline of 0.5 mb/d. (See figure.) While shale producers have subsequently reworked their economics to reduce costs, allowing production to resume growth at much lower prices, there is no longer the concern that production cannot be reined in by lower prices.
At the same time, supply disruptions have become minimal, with Libya, Nigeria and Venezuela all continuing to have difficulties but few sharp moves, as the figure below shows. There is certainly a possibility that any one of them will experience an abrupt change in production (downward especially) but as time passes without such happening, traders become less worried about the likelihood. (Understanding the actual probability of a disruption involves an intimate knowledge of the political situation on the ground, as well as the technical functioning—or not—of the local supply infrastructure. Much easier to just look at the recent behavior and assume it will continue.)
And the OPEC/non-OPEC reduction in production means an increase in unused capacity outside of Saudi Arabia, something that has been uncommon in recent years but which theoretically stabilizes the market, as it represents a reserve of surge capacity to cope with unexpected supply problems. Unfortunately, as the table below shows, about one-third of the ‘available’ capacity is not really, that is, it consists of underproduction by Mexico and Venezuela which represents involuntary production declines. Remove Saudi surge capacity as a special case and there is only about half a million barrels a day of available surge capacity to cope with problems.
On the down side, there is always the possibility that demand will surprise, especially if a recession begins overseas in countries like Brazil, India or China where economic data is often poor and typically delayed. For almost two decades, warnings of unsustainable debt in China have threatened an economic slowdown which has not occurred, but such remains a possibility.
Which raises another question, that of inventory shifts. The Chinese appear to be quite adept at buying for inventory when oil prices are low, and drawing them down when prices rise cyclically. The swing in demand for imports can easily be 1 mb/d, which can exacerbate short-term market moves.
Ultimately, the success of the OPEC/non-OPEC production agreement of December 2016, with compliance far better than previous agreements, even if some of it is unintentional (Mexico and Venezuela), reassures traders that future downward pressure on prices will be dealt with, at least for a time, while upward pressure on prices will trigger such a strong response in the U.S. shale fields that the non-U.S. producers will have to react to moderate them. Although there will be talks between U.S. shale producers and senior OPEC officials this week, the reality is that U.S. producers are an ultra-independent group, and trying to get them to coordinate with other nations’ producing companies would make herding cats look easy.
