COMMENT: Low oil prices will solve low oil prices in 2016

COMMENT: Low oil prices will solve low oil prices in 2016
By Kim Iskyan of Truewealth Publishing December 22, 2015

A lot of people, and countries, like lower oil prices. It's good for consumers because they pay a lot less to heat their homes, cook their food, and drive their cars, scooters or three wheelers. It's also good for countries like Singapore, the Philippines and Hong Kong, that import most of their oil.

But when oil prices hit 11-year lows, like they did yesterday, it's bad for oil producers like Russia, Brazil and Saudi Arabia, who depend on revenue from producing and selling oil to keep their economies going. So the 68% collapse in the price of oil in 2015 - to lows not seen since the global financial crisis, again hitting new 2015 lows this week - has hurt them. It's also hurt the share prices of energy companies. And it's been a huge disruption to global markets.

But the chances are good this is all going to change again in 2016, because, similar to the case with other commodities, low oil prices are going to be 'solved' by...low oil prices.

A few years ago, a lot of people thought the world was running out of oil. That turned out to be completely wrong. Oil production has increased in recent years, most notably in the US, where it's
doubled in the past six years. The US is now producing so much oil that the government just lifted a 40-year ban on exporting crude oil.

Higher US oil production has been driven in part by advances in oil and gas production technology. These allowed for oil that was previously not profitable to pump, to become profitable at a lower price level. In part because of this, the overall amount of oil produced worldwide has been rising.

Meanwhile, other big oil-producing countries have kept on producing the same amount of oil, if not more. The Organization of the Petroleum Exporting Countries (OPEC), a cartel of 13 oil-producing nations, has in the past worked to keep the price of oil at a certain level or range. Members would together decide to cut (or increase) oil production if they thought the price of oil was too low (or high). They tried to manipulate the oil market to suit their needs.

There are two problems with this, though. The first is that OPEC accounts for only about a third of all oil production. So countries that aren't in OPEC, like Russia and the US (two of the biggest three oil producers), don't have to do what OPEC wants. They can make more oil – like the US has been doing – and ignore what OPEC says about the price.

The second problem is that even OPEC members don't have to listen to what OPEC says. Oil-producing countries all benefit from high oil prices. But no country wants to cut production (thus reducing its own income from selling oil) to help boost oil prices by reducing supply. So, even if OPEC tells its members to cut production to try and boost the price of oil, those members often do what they want anyway.

But since the price of oil started falling in June 2014, OPEC hasn't focused on cutting production. In fact, it's done the opposite, allowing members to pump more oil so OPEC's relative proportion of oil
production doesn't drop. At a meeting earlier this month, OPEC didn't even bother talking about limiting production.

Instead of making as much money as possible from their oil – by finding the right balance of production and price – OPEC has decided to keep pumping. Since the first quarter of 2013, OPEC's oil production has risen 4%. But oil demand hasn't increased as fast as oil supply. The global economy hasn't needed more oil. Since the first quarter of 2014, there's been more oil supply than there is demand. It's not a coincidence that the price of oil peaked in the second quarter of 2014, and that it's been falling ever since.

The amount of excess oil is small. It's less than 2% of total production. But this has a big impact on the price of oil, and has played a big role in pushing down the price.

So what happens next? OPEC (mostly Saudi Arabia, as not all OPEC members agree) wants to squeeze out the higher-cost oil producers that have been adding to the total supply. For example, US shale oil that might cost $60 (or more) per barrel to produce isn't profitable when oil is at $40 per barrel. The shale oil companies don't want to stop production, since they still have costs to cover, and would rather make less, than make nothing at all.

But that can last for only so long. Some of these high-cost producers are facing bond payments that they might not be able to make. Others have been cutting production rather than lose money on every barrel.
So OPEC's plan seems to be coming together. Lower oil prices are slowly pushing out some of the new, extra oil that's now too expensive to produce. "There is evidence the Saudi-led strategy is starting to work. Lower prices are clearly taking a toll on non-OPEC supply," wrote the International Energy Agency on December 11.

This will eventually push higher-cost US producers (which, at a lower oil price, aren't profitable anymore) out of the market. But what if other oil producers start making more oil? For example, Iran
hasn't been able to export oil because it's been subject to  international trade sanctions. Once those sanctions are lifted, the Iranian government will want to earn as much as it possibly can from its oil – and it doesn't care about the price. Depending on how much oil Iran adds to the mix, that could further hurt the price of oil, or delay its recovery.

Right now, it's likely that OPEC will win out – even at a huge cost to their own revenues. They'll squeeze the other oil producers, supply will fall and the price of oil should rise. That's good news for some countries – but bad news for everyone else.

What can you do about this? Loading up on cheap petrol before the price rises isn't feasible for most people. A better alternative is to look at the shares of oil companies in countries that have suffered the most from low oil prices, like Russia. Some of these companies, liked London-listed LUKoil, stand to benefit from a higher oil price, as well as from the improvement in the macroeconomic environment.

Kim Iskyan is the founder of Truewealth Publishing and the editor of the Asian Investment Daily.