Why Are Oil Prices So High When The U.S. Remains One Of The World’s Largest Producers?
The current oil market is unusual. The Covid-19 pandemic has created funkiness and dislocations across the global economy, and the energy sector is no exception. This is not merely a U.S. issue, energy markets are global, and while America remains a top producer, many other things are going on in the market.
Today, we’re in a situation where global oil demand is rapidly recovering back toward pre-pandemic levels due to widespread vaccinations in the largest oil and gas-consuming economies (the U.S., China, Europe). Life is getting back to normal, with greater mobility, traffic patterns.
Global consumption of all refined products, except for jet fuel, is effectively back to pre-pandemic levels. Jet fuel continues to be held back by constraints on international flights, but it’s game on for gasoline, diesel, heating oil, etc.
So, we’ve established that demand is surging. How about oil supplies? OPEC+ has kept a tight grip on supply since it agreed to its historic production cut deal in May 2020. It has not only sought to balance supply with demand as the world emerges from the pandemic — but it also has sought to restore petroleum inventories to normal levels.
Inventories of petroleum shot up massively during 2020 amid peak lockdowns. So, OPEC+’s job has been two-fold over the past 16 months — hold back enough supply to
meet demand but not oversaturate the market and make sure that global inventories for both crude oil and refined products drain. That takes exceptional supply discipline, and the Saudi-Russia-led cartel has delivered. OPEC+ has been so successful that oil prices have been steadily rising since Brent dropped below $20 a barrel at the pandemic’s peak in the spring of 2020.
OPEC+ has begun the process of easing supply cuts by adding 400,000 barrels a day each month. Global inventories are now close to “normal” pre-pandemic levels, but OPEC+ remains hesitant of adding more supply at this time, even though major consuming nations including the U.S., Japan, and India have urged them to.
Why is OPEC+ not adding more supply despite prices over $85 a barrel? Because it remains wary about demand in the coming months and 2022. It remains concerned about fresh Covid-19 outbreaks, particularly after the experience with the Delta variant and their potential to curb demand. Just look at what’s happening in Eastern Europe and Russia right now — fresh outbreaks have brought about new lockdowns or mobility restrictions.
OPEC+ also knows that the recent surge in Brent prices to over $85 has been caused by the global spike in natural gas prices. The gas price spike is predicated on fears of a cold winter in Europe and Asia, but prices could fall off sharply if this colder-than-normal weather does not materialize. At present, the feeling is that some power generators with the capability to switch from expensive gas as feedstock will switch to oil products this winter, which could boost oil demand by 400,000 barrels a day to 1 million barrels a day.
OPEC+ is also eyeing the early 2022 oil market. Winter could bring more Covid cases, and spring is a lower-demand “shoulder” season. Adding more supply over the 400,000 barrels per month could result in an oil surplus forming in early 2022. OPEC+ does not want to go back to square one with reducing inventories.
While most experts forecast that global oil demand will return to pre-pandemic levels of over 100 million barrels a day next year, much of the heavy lifting will occur in the second half of the year. The summer months in the Northern Hemisphere — the so-called peak driving/flying season — account for much of the demand growth in any year.
What to expect from OPEC+ at its next meeting on Thursday, Nov. 4? The cartel is expected to keep its current agreement in place and not add more supplies than the previously agreed 400,000 barrels a day each month. Group leader Saudi Arabia has already said that it sees no demand in the physical market for additional barrels. It has also lowered prices for Saudi “spot” barrels — a move that reflects this. Yes, oil markets are tight — but there is no shortage of oil available to global refiners.
One thing OPEC+ could address is that over the past two months, it has been adding less than the agreed to 400,000 barrels a day. It has been over-complying with its supply pact because some weaker members, mainly from West Africa — Nigeria and Angola — have been unable to produce at their quotas due to operational, technical, and investment issues. The larger cartel producers like Saudi, Russia, or the UAE could step in and fill that void, which could add supply and perhaps take some heat out of prices.
OPEC+ will likely test how high prices can go without hurting the global economy while waiting to see when higher prices result in a non-OPEC production response. Members, after all, benefit immensely from higher prices in their oil-dependent state budgets.
What about the U.S.? Why isn’t shale responding to higher prices with solid growth? While U.S. production is rising and will continue through the end of 2022, it remains well below pre-pandemic levels of 13 million barrels a day. U.S. production is now slightly over 11.1 million barrels a day — up from 10 million barrels a day at the peak of the Covid-19 price collapse in 2020. That’s a strong rebound. The U.S. Energy Information Administration expects output to average 11.3 million barrels a day in December, which would put the 2020 average at 11 million barrels a day. Production will keep rising in 2022, exiting next year at around 12 million barrels a day, for an average of 11.7 million barrels a day. That’s substantial growth — but it remains 1 million barrels a day below the pre-pandemic peak.
What is explicitly holding U.S. producers back from drilling and fracking more with prices at $85 and some experts anticipating $100 soon? It’s mainly investor demands for higher financial returns. ESG (environmental, social, and governance) concerns have also weighed — and are building as the Biden administration unleashes its climate plan. Investor demands for higher returns from shale existed before Biden arrived. They were prompted by massive capital destruction by shale producers in the years before the pandemic struck.
Then, when the bottom fell out of prices a year ago, these demands were super-charged. The same could be said for ESG. These concerns existed before Biden, but his climate policies send a stronger message to producers and investors about Washington’s hesitancy to remain a top oil and gas producer. So, now the ESG concerns have been turbo-charged by Biden policies like the termination of Keystone XL, the attempt to halt federal oil and gas lease sales, and aggressive efforts to regulate methane emissions.
The other concern for producers is that oil futures markets are in “backwardation” — a market structure where prices months and years down the line are lower than current prices. That means investors are expecting lower prices in the future, which means $85 oil may not last, making it riskier to increase investments in new drilling and fracking.
Why is the Biden administration begging OPEC+ to add more supply when the United States has extensive reserves and remains a top global producer? Biden must tackle two somewhat conflicting agendas simultaneously — rising energy prices in the short-term and climate change in the long term. He must address rising energy prices — gasoline pump prices are now up over $1 a gallon during his administration to a seven-year high. But he also can’t be seen by the progressive wing of the Democratic party as being pro-oil in promoting domestic output. The net result is policies that look hypocritical.
On the one hand, the administration is correct to lobby OPEC for more supply NOW because OPEC is sitting on over 6 million barrels a day of spare production capacity that can be brought on quickly. The same can’t be said for the fragmented U.S. oil sector, where hundreds of companies must decide whether to pursue growth and move the needle on overall U.S. output. The U.S. oil sector can’t do that in a snap like OPEC+ can. It’s more a process for the U.S. industry to mobilize and increase production.
But on the other hand, Biden continues to send messages to the industry and world that they wish to increase dependence on OPEC+ and imports — this remains bullish for short- to medium-term commodity prices. That perpetuates the high energy price problem that the administration faces. Simply offshoring greenhouse gas emissions from oil and gas to OPEC+ does not tackle climate change while hurting the U.S. economy. Globally, emissions are likely to go up from such policies because the industrial activity will move to less regulated, higher emissions areas in OPEC+.
The question is, why doesn’t the administration incentivize production while simultaneously upping emissions regulations? Such a strategy would displace the need for imports and reduce prices at the pump. Look no further than Norway, the largest producer in climate-conscious Western Europe. The EU is more serious about climate goals than the United States but insists that its oil and gas sector continue to be developed, not dismantled. Given that they produce among the lowest carbon-intense barrels in the world, this makes a lot of sense. The Biden administration can easily regulate domestic production — but it cannot easily do the same for foreign production.