Column: Geopolitical events demand rapid response from unconventional producers

Daniel Fine

The West Texas Intermediate price per barrel has recovered since the low of the mid-$40 bottom to slightly above $60. This has become a trading range with algorithms following momentum making a price range. Financial or paper traders and speculators have moved the price of oil in a “rally” up $15.

Oversupply still overshadows the market. The balance of supply and demand awaits the onset of winter or 2016. The market share for OPEC and Saudi Arabia continues to expand at the expense of non-OPEC producers, but American shale or unconventional production has not declined to the point that an acceptable world balance between supply and demand appears to be in the making.

The CEO of Conoco Phillips was invited to the recent preliminary OPEC meeting and he challenged the producer countries with a warning: American “high cost” production will survive the price war with cost-saving efficiency already in process and yet to come. This promises American oil supply at less cost and a prospect of little change in world supply while demand remains weak and possibly weaker with China importing less crude as well as iron ore and other commodities.

What is now at play in oil price formation is geopolitics.

The Gulf in the Middle East is in a war — Shia and Sunni, Iran and Saudi Arabia — with the frontline in Iraq .

Is the Islamic State of Iraq and the Levant (ISIS) a threat to the OPEC supply of crude oil? The reality “on the ground” is negative. ISIS requires the revenue from oil and not its disruption.

If, however, one day there is a confirmed attack upon Saudi Aramco oil fields and refinery infra-structure, the speculators and hedge funds will buy oil and the price could reach $75 or more per barrel. If the damage was serious enough to take Saudi production off-line at the rate of 300,000 barrels per day the price of oil could approach $90.

Libya is too small a producer to matter as a geopolitical variable in an upward price move.

Military events in Iraq could affect oil production in a downward supply scenario. However, no war induced “scorched earth” option is likely as the Kurd interest continues to sustain oil production and pipelines to export markets.

At the end of the month, the geopolitical impact of a nuclear non-proliferation treaty with Iran would release Iranian oil supply from the constraints of sanctions. Iran can export 1.5 million additional barrels per day. The Iranian post-treaty supply to an over-supplied global market would lower the price of West Texas Intermediate indirectly to a range of $38 to $46 which eliminates the recent rally of this year.

It is not clear if OPEC can manage the Iranian supply which creates new conflicts for the cartel. It also creates cash flow pressures upon Southwest and Dakota unconventional producers and a new round of efficiency and cost measures.

The other principal geopolitical threat to the price of oil is Russia and Ukraine. While the conflict is seen in Europe from the perspective of natural gas supply and dependence, the potential disruption to oil supply or Russian exports is serious. Russian production is now well over 10 million barrels per day with exports at 75 percent.

Should the Minsk standoff agreement fail and military confrontation expand, the market perception would factor in a war over resources with accidental events escalating into a NATO response via Eastern European members. Naval interceptions of Russian crude oil would drive the financial services to speculative buying of oil. The West Texas Price of oil would reach $100 per barrel before U.S. Government margin (deposits in the future markets) restrictions and attempts at market containment.

The South China Sea is a new threat since it is the sea-route of Middle East oil to Asia. China is building an island-base to defend its supply of oil imports. Vietnam in particular claims the same territory and has the capability to challenge China. Gun-boat diplomacy or worse will be buy signals to oil traders from now on.

Geopolitical events such as these are short-lived.

Physical supply and demand remains the long-term reality of the oil exploration and production company.

The price war, or market share OPEC alignment, is against the unconventional producers in the San Juan and Permian basins. They must have a rapid response capability in their corporate structure to capture momentary price surges based on geopolitics through hedging. This is selling forward through derivatives and exchanges in a geopolitically induced upward price move. And this depends on timing in the hedging — or financial departments — which has nothing to do with management at the bore hole.

Daniel Fine is associate director, New Mexico Center for Energy Policy at New Mexico Tech, and project leader of the Energy Policy, state of New Mexico, Department of Energy Minerals and Natural Resources.