Oil prices have risen over 20% since the OPEC production cut agreement at the end of November. While concerns abound on quota cheating and increased production from Libya, Nigeria and US shale, the incoming US administration could change the market completely through strategic oil sales and new import taxes.
The paralysis of OPEC between the summer of 2014 and November of 2016 was primarily due to the uncertainty in the equation introduced by US shale oil production.
Shale had much shorter production cycles than other forms of oil and had been financed by a huge debt and equity boom in the sector spurred by low interest rates, piling into exploration and production.
To the Saudis, who would have to lead any cut, this presented a conundrum as it was uncertain if shale producers would rapidly step in to fill any production cuts. This would have been a wealth transfer from Saudi to the shale producers, which was intolerable.
The equation has now changed for Saudi as they tap capital markets for sovereign debt and the upcoming Aramco IPO, meaning they would come out ahead regardless of shale and cheating.
The next few months are vital for the oil market as adherence to OPEC quotas and a potential supply resurgence from disruptions in Libya and Nigeria are monitored, particularly as Russian participation is conditional on no cheating.
However, an unexpected shift in the balance of the oil market in the next few months could be the actions of the incoming US administration under President Trump.
While the President-elect has shown flexibility on many of his pledges, the one area he has shown consistency and made appointments in line with his stated stance is on trade, moving the US in an mercantilist direction.
If trillions of dollars leaving US shores for cheap goods from China is intolerable, the idea of being dependent on OPEC oil, produced at a significant discount, is even worse.
An “America First” stance and renewed focus on North American energy independence could lead to two significant changes: a resizing of the Strategic Petroleum Reserve (SPR) and introduction of a border adjustment tax.
The SPR was established in 1975 after the 1973–74 oil embargo to mitigate against future temporary supply disruptions. The SPR holds 695 million barrels of oil, with a maximum withdrawal rate of 4.4 million barrels per day.
As a member of the International Energy Agency, the US must stock an amount of petroleum equivalent to 90 days of imports. Due to the surge in local production, net oil imports are now oil 4.8 million barrels a day versus a peak of 13.3 million barrels per day in 2005. As such, the SPR now holds 265 million excess barrels of excess oil.
A mercantilist administration could legitimately authorize a release of a million barrels a day to rebalance the SPR.
A drawdown of 190 million barrels has already been announced by the Department of Energy over the next 8 years, but there is no reason this could not be accelerated.
This would completely undo the OPEC deal, based on cuts of 1.2 million barrels a day and likely lead to a rush for market share. This would also drop gasoline prices, helping the US consumer.
While this would pressure US shale producers, many of these companies have taken the opportunity of the recent oil rally to hedge future production. The proceeds from the SPR release, likely over $10 billion, could be used to kick start energy infrastructure investment designed to further increase US energy independence, such as outlined in the “Pickens Plan” from 2008.
This fits with Trump’s plans for a trillion dollars of infrastructure spending, but another of his proposed policies, a border adjustment tax, part of the “Better Way” reform package, could cushion the blow of an SPR release for shale producers.
Under this policy, imports would be taxed at the new corporate income tax rate of 20% and income earned from exports would be tax exempt. While the impacts of this proposal are far-reaching, it gives domestic US oil producers an immediate 25% price advantage over imported oil and would most likely cause the dollar to spike by double digits.
This could cause gasoline prices to increase by as much as 30 cents to a gallon per a recent paper by Philip Verleger and the Brattle Group, but an SPR release would offset this.
Imports from the Gulf would collapse to almost zero in this scenario, with a resurgence of US energy investment potentially leading to a supply surge to fill this gap in future. SPR sale revenue could also discount gasoline taxes in the adjustment period.
While the oil market is anticipating an orderly tightening of supply conditions, these actions would change the game, placing the balance of power firmly with the USA absent a significant change in strategy by OPEC and other major producers.
As such it may now prove wise to be wary on the potential for oil prices in the near term, with demand dependent on whether Trump follows through on his planned mercantalist stance on trade.