In this week's MacroVoices podcast, Erik Townsend and Joe McMonigle, former chief of staff at the US Department of Energy, discuss the state of the global energy market, and OPEC’s rapidly diminishing ability to control oil prices. McMonigle believes investors will be hearing more jawboning from the Saudis, OPEC's de-facto leader, over the next two weeks as they try to marshal support for extending the cartel's production-cut agreement past a March 2018 deadline.

Of course, anyone who’s been paying attention knows the cuts have done little to alleviate supply imbalances that have weighed on oil prices for years. In a report published by the International Energy Agency earlier this month, the organization notes that non-compliance among OPEC members, and non-members who also agreed to the cuts those non-members who also agreed to cut oil production, increased again in July. According to the IEA data, non-compliance among the cartel’s members rose to 25 percent in July, the highest level since the agreement was signed in January. Meanwhile, noncompliance for non-members rose to 33%.

Given that oil prices have fallen since OPEC members and non-members first agreed on the cuts last November, the Saudi's might have difficulty convincing their peers that the cuts are having an impact, other than allowing US shale producers to flourish.

OPEC will meet Nov. 30 in Vienna.

Erik: Joining me now as this week’s featured interview guest is former US Department of Energy Chief of Staff Joe McMonigle, who now heads up the energy research team at Hedgeye. Joe, I think everybody understands that the key question in today’s oil market is whether the rebalancing that OPEC production cuts were supposed to achieve is really happening or if the supply glut is actually still continuing. So let’s start with your high-level view first. Is OPEC effectively managing supply or are they really just managing market sentiment?

Joe: I think, to date, they have been managing sentiment and, of course, engaging in verbal intervention in the market. Yes, they did do this production cut deal a year ago—well, actually last November. They’re eight months into that deal now, and it’s really had not that much of an impact on the market. I think, originally, when the deal was announced, I think oil bulls really liked the idea and prices were boosted as a result. But many people, a lot of very savvy oil analysts and forecasters at banks, predicted big inventory draws in the spring that just never materialized. And, of course, the return of higher prices has incurred shale to rise—which, of course, we can get into later because It’s sort of a different phenomenon. But, just to really judge the effectiveness of the production cut deal, last Friday oil ended at—or settled at—47 and some change. It was actually a penny lower than it was a year ago.

So, just to judge—obviously, prices in the last couple days have fluctuated a little bit—but, really, if you’re looking at where prices were a year ago versus where they are today, I don’t think you can really say that the production cut deal has had a lot of influence or has been very effective. And I think as a result the markets started out really impressed, and I think they’ve been pretty disappointed as we’re into month eight now, almost nine months of the deal.”

In the coming works, McMonigle said he expects "two competing narratives" to emerge in the oil market. The first, advanced by the Saudis, will be news of large export cuts, particularly to the US. The other will be the story of rising shale production.

“Erik: OPEC has another meeting coming up on November 30th. And, as we all know, they’re in the habit of using the periods leading up to these meetings to jawbone the market with their various propaganda announcements. So, there’s been talk about the production cuts maybe being extended, or even increased, at this meeting. There’ve also been rumors about maybe taking exempt countries that didn’t participate in the cuts and making them not exempt next time around.

So, what do you see actually happening on November 30th? And how do you think the propaganda campaign is going to play out between now and then?

Joe: I think you’re totally right; jawboning is really part of the OPEC playbook. And I think you’re going to see it in the next two weeks now—even before August is over—I think two competing narratives. One, you’re going to start seeing from the Saudis announcements or leaks about big cuts in crude exports, particularly to the US. And they sort of signaled that they were going to do that in July. I certainly expect them to have done it. Of course, a lot of it has to do with lower demand from China as well. But they will show some big cuts, I think, in crude exports. And then juxtapose that with, I think, what you’re going to see from the US—which we’ve seen really, I think, throughout the summer—and that’s really rising US production—and a lot of other forecasts from banks and other oil analysts about rising US production. And I think Barclay’s came out with a forecast report earlier this week or late last week that had oil going to ten-and- a-half million barrels a day by the end of 2018.

So, I think you’re going to start seeing more of that, and I think that’s really making it difficult for OPEC to regain the narrative about the production cut deal. And I think they badly want to try to get that back. In terms of the next meeting, already, yesterday, you had the Kuwait oil minister say that they’re going to make a decision to consider whether to extend the production cut deal or to basically end it. Unfortunately, neither of those scenarios is really what the market wants to hear. I think the market wants to hear that there’s going to be deeper cuts, and that’s really not been on the table. I think there was some potential anticipation of that, potentially at the last OPEC meeting. We thought there really Wasn’t a chance of that happening. We wrote a note for clients that basically said—“longer not deeper” was the title of our note.

I think at the very least you’re looking at another extension. Even though it’s extended into the end of first quarter 2018, I think they will probably want to signal at that November meeting that they will extend. I think that’s at a minimum. However, I would not preclude, potentially, more drastic action at that meeting. But I think it’s too early to tell. I think we have to really see where the market is in late October and early November.

And I think the main reason for that is really the Aramco IPO coming up. And I think it’s just—we’re going to talk about that later I think—but I think that’s really, it’s a central focus of the Saudi Arabian government, of their economic reforms, so they have a lot riding on it. And, therefore, I think there’s the potential that there could be some unilateral Saudi action of deeper cuts.

So that’s something I now put in the realm of possibility as I look at the different options coming up at the November 30th meeting.”

While inventories data released in recent weeks have shown large drawdowns in the US, McMonigle said any declines have been more than offset by climbing shale production. 

"Erik: I want to come back to the Aramco IPO in a few minutes, but let’s start with touching on the official US data that comes from your former employer, the Department of Energy.

It used to be pretty easy to read these reports, but lately we’re kind of getting conflicting data. There were quite a few much bigger than expected drawdowns in crude oil inventory in recent weeks, although this week it appears to be much more in line with inventory, around a 3 million barrel drawdown, which is for this time of year pretty normal.

Those big drawdowns would have been very bullish. But then we also see that there’s been steadily increasing domestic production in these Wednesday reports. That would be a bearish sign. But then on Fridays we get the rig count, which looks like it’s finally starting to level off a little bit. So that would tend to go the other way.

When you net all these things together, what do you see in the data? Are we looking at a bona fide rebalancing of the market that’s actually occurring? Or is there still a production glut?

Joe: I guess I side on the production glut side. I think—certainly there’s been some drawdowns, and I think that’s positive news. It’s hard—it’s impossible to say it’s not positive news, although I think most observers thought the drawdowns would occur sooner and they’d be even greater than they are. But a sustained several weeks now of drawdowns, I think has been positive. As you point out, the signals, however, about rising US production to really record levels, and the resiliency of US shale, I think is really a big counterweight to these inventory draws.

Now we’re also entering a phase here where the end of summer, the high demand season, is going to be switching over. And there’s going to be refinery maintenance, and—so I think a lot of the contributing factors, in terms of gasoline and other product inventories, are probably going to start stalling out. And so I think you’re going to see the market struggle here in the fall, even with further draws.

And, of course, crude exports from the US, which now are allowed as a result of lifting the crude export ban in 2016—I think, first of all, no one really thought, until prices really recovered to big levels, that there would be significant exports. But, again, the market has really been surprised, I think, about very strong crude exports. And of course that’s affecting the drawdown numbers as well.

So I think it’s a much more complicated data array to consider now, as we go into the fall. And I think—definitely you put your finger on it—the US production number, I think, is the big complicating factor in what would otherwise be very bullish news."

The former DoE chief also had this interesting detour into the petrodollar system:

Erik: A lot of people think the reason that the US dollar has remained the world's reserve currency, 45 years after the Bretton Woods system collapsed in 1971, is the so-called petrodollar system in which Middle East oil producers price their oil in US dollars regardless of who it's being sold to. And many of those nations also reinvest their profits in US Treasury Bonds.  But recently we're seeing pressure from Russia and China to stop transacting in dollars. Iran, in particular, seems to have come to favor Euros over dollars for its oil exports. So do you think the petrodollar system—or even the US dollar's hegemony as the global reserve currency—is at risk in the longer term in light of these developments? And what do these changes mean for the price of oil as you look ahead?  

Joe: First of all, I don't profess to be an expert on currencies and its impact on oil prices. But certainly, historically, there's been an inverse relationship between the dollar and oil prices. I do think the supply glut has kind of interfered a bit with that relationship. And it hasn't necessarily worked as clockwork as it has in the past. I'm not sure the moves by China and Russia are really going to have that much of an impact, or any impact at all. So I do think the dollar really remains the preferred currency, not just in oil but in commodities in general. 

I will tell you an interesting story from my time at DOE. When oil prices really surged to $100 levels, the Saudis—and in particular Minister Al-Naimi, at the time the oil minister of Saudi Arabia—really talked out loud about potentially changing the currency for oil prices from dollars to Euros, just so that they could lower those skyrocketing prices they felt were impacting demand and having a greater impact on markets than it probably should. So, certainly I think market participants are looking more at currencies right now. But I don't really put much stock in the moves—or the noise, I guess I would characterize it—from Russia and China.

This is just a modest selection of of the items discussed on the interview which also includes:

• Is the oil supply glut rebalancing?
• Is OPEC just jawboning the market?
• Import data impacting oil inventories
• Outlook for U.S. oil production
• Update on Venezuelan geopolitics
• What can go wrong with Iran?
• Is the Petrodollar system at risk?
• Is the Saudi Aramco IPO going to happen?
• Is the term structure signaling bullish prices

Listen to the rest of the interview below:

Audio length: 01:21:38