“What most of these doomsday scenarios have gotten wrong is the fundamental idea of economics: people respond to incentives. If the price of a good goes up, people demand less of it, the companies that make it figure out how to make more of it, and everyone tries to figure out how to produce substitutes for it. Add to that the march of technological innovation (like the green revolution, birth control, etc.). The end result: markets figure out how to deal with problems of supply and demand.” – Steven D. Levitt
“The only thing about sanctions is that, like a lot of drone strikes, there are countless unintended victims.” – Henry Rollins, American musician
“The English language has 112 words for deception, according to one count, each with a different shade of meaning: collusion, fakery, malingering, self-deception, confabulation, prevarication, exaggeration, denial.” – Robin Marantz Henig, contributing author to the New York Times
Mancur Olson in his seminal book The Logic of Collective Action: Public Goods and the Theory of Groups challenged the prevailing wisdom during his time and developed a theory of collective action, commonly referred to as Olson’s Paradox, to explain why the existence of a common interest among a group of people is not sufficient to induce cooperative behaviour amongst the members of the group.
Olson argued that “unless the number of individuals in a group is quite small, or unless there is coercion or some other special device to make individuals act in their common interest, rational, self-interested individuals will not act to achieve their common or group interests.” In a scenario where a change is being proposed and there are two rival groups contesting said change, and the number of members in one group vastly outnumbers those in the other group, the theory poses that the smaller group will have an organising advantage over the larger group and is thus far more likely to achieve a winning outcome.
Oil importing nations greatly outnumber oil exporting nations. And it almost goes without saying that rising oil prices richly benefit oil exporting nations while the gains of declining oil prices are more modestly divided amongst the oil importing nations. Oil exporters then have both (i) a greater incentive to push up the price of oil than do oil importers to push it down and (ii) an organising advantage. It is this combination of incentive and advantage that enabled OPEC and Russia et alia (NOPEC) to implement and maintain joint production cuts that stabilised and eventually propelled oil prices higher.
Oil prices have ripped higher this week, the price of Brent Crude has pushed through the US dollars 80 per barrel mark – a level previously unreached since the collapse in oil prices in late 2014; the level may have remained unreachable had it not been for the Trump Administration’s reinstatement of economic sanctions on the Islamic Republic of Iran in May this year.
The catalyst for this week’s push higher is seen to be the lack of response coming from the OPEC-NOPEC alliance to President Trump’s protestations for an increase in production to cool prices. Mr Trump, it seems, is asking for his vig as the bully who ejected Iranian oil from global markets.
Even though OPEC did indicate that it has the necessary capacity to replace Iranian supplies markets remain concerned about a supply deficit next year, especially with infrastructure bottlenecks limiting supply from shale.
The International Energy Agency (IEA) estimates oil demand growth to average 1.5 million barrels per day in 2019. Assuming that the moderate pace of global economic growth anticipated for 2019 is not derailed by the on-going trade conflict between China and the US, realised demand levels should not differ significantly from the estimate.
The supply side is where the challenge, we think, lies.
In the absence of renewed sanctions on Iran, the supply-demand dynamics would have remained evenly balanced. Shale production has continued to exceed expectations; US production has reached 11 million barrels per day – increasing by 1.6 million barrels per day over the course of the last 12 months. With oil prices as high as they are, shale producers are likely to continue pushing for increased output and US production may well continue to surprise to the upside.
The impact of the Iranian sanctions on the oil supply-demand dynamic will come down to China and whether it chooses to comply with the US-led sanctions or not. We think China, at least in the near term, is far more likely to reduce (or completely halt) oil imports from Iran. Our thinking is led by the fact that the major Chinese oil corporations, such as SINOPEC, are listed on the New York Stock Exchange and have sprawling global operations that can easily be targeted by the US. Given the ZTE experience, the Chinese leadership, we believe, is unlikely to want one more of its national champions to get caught in the Trump Administration’s cross hairs.
If we our correct in our thinking on China, oil markets will end up losing a large chunk of the 1.5 million barrels per day of Iranian output starting November. Add this to curtailed Venezuelan output and the world could find itself in an oil supply deficit anywhere in the range of 2 to 4 million barrels per day in 2019, depending on how shale and OPEC production ramps up following the sanctions.
Investment Perspective
The figure of US dollars 100 per barrel of oil has been bandied in headlines recently. We think the three-figure market is largely symbolic and not one that concerns us much. Nonetheless, given the high likelihood of a supply deficit occurring next year, we expect oil prices to remain high (if not move higher) until we see a meaningful supply response or an unexpected drop in demand.
We have been long the SPDR Energy Select Sector ETF $XLE since late October last year and remain long.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.