Commentary – Defining the Swing Producer
The oil price war continues.
Saudi Arabian engineers are getting close to red-lining their output. Newsfeeds and data show that the Kingdom is flowing 10.3 MMB/d, within 16% of their published maximum capacity. For now world prices are balancing in the mid-$60 range, but there is concern of another price slide before another go-around of see-saw volatility.
Isn’t it odd how commodity prices are prone to playground metaphors? Maybe so, but the implications of unstable oil supplies are far from fun and games. Here’s another one: How about, “swing producer”? A term that is commonly misinterpreted.
In world oil markets, Saudi Arabia was long held out to be the “swing producer.” Some say the United States now takes on the shadowy honor. In truth, neither is capable of holding the title today. What we are seeing are two playground bullies fighting over one swing. The results are predictable: No one will be allowed to swing and all producers will have to live with the consequences of more volatility.
By definition a swing producer is a supplier that has a large amount of spare capacity; so much so that they can influence market prices by ratcheting their output up or down at will. Typically, swing producers try to “balance”, or artificially regulate the market to keep prices robust and stable.
Swing producers don’t hide their intentions. Like visible hands of opportunism, they act for the economic benefit of one side, the supply side. Although the swing producer’s competitive peers often benefit from its manipulative actions, the self-interest of optimizing its own market share and profitability is the prime motivation.
An example of a swing producer is De Beers, the diamond-mining giant that tightly controlled the market for the coveted mineral in the 20th century.
Back to Saudi Arabia. The Kingdom’s state-owned oil enterprise supplies 11% of the world’s oil needs and holds nearly all of its spare capacity. As the de facto leader of the OPEC cartel it’s long been viewed as a defender of oil prices with one ear to the market and two hands on a pipeline valve.
Historic data shows only occasional correlation between Saudi production and price movements. Over the past 40 years, most oil price volatility is the result of large step changes in global demand or supply, not Saudi actions. When an economic recession causes oil demand to take a U-turn; when new technologies like offshore drilling or tight oil unleash a surprising surge in supply; or when a producer with outages is able to quickly ramp up their production, as Libya accomplished late last year. Often, these supply-demand disconnects are amplified by the lag between price signals and the amount of time (years) it takes to build big production platforms and facilities.
Another defining characteristic of a swing producer is that they have the ability to adjust their production quickly without incurring extra cost. In other words, it’s a matter of turning a few small dials to get an output response as opposed to the slower task of turning big drill bits to bring on additional, expensive wells.
The advent of the light oil revolution in North America, has led some to suggest that Saudi Arabia, and their cartel partners in OPEC, have ceded their market power to a new swing producer: The US oil industry. This expanded definition confuses the meaning of a swing producer.
The oil industry in the US (and Canada too) is composed of fiercely competitive companies, none of which has enough controllable production volume to sustainably alter prices in one direction or other. In addition, none of these companies have any intention of consciously reducing output when prices are high. In fact, after living through about eight months of low oil price, production from US suppliers is still growing. Producers have yet to demonstrate the level to which output can be reduced when prices are low. Unsurprisingly, the behaviour of North American producers is in line with that of fierce competitors rather than market custodians trying to willingly regulate price volatility.
Contrary to belief, the US shale oil business cannot quickly counter balance price movements. Ramping up output in meaningful quantity – at least several hundred thousand barrels a day on short notice – requires the dispatch of hundreds of rigs and a lot of fieldwork to tie into pipelines. And we are witnessing in real time that the reverse response to falling price has been slow in coming too. Collective production remains stubborn, which is hardly an effective response to price volatility, but is actually an appropriate response to a price war.
Nor does the US tight oil supply chain have the ability to respond without additional cost. Low prices are beating up the oilfield service segment of the industry. Weekly equipment auctions and tens of thousands of layoffs mean that any oil price rebound will be met with diminished field capacity and another round of rising day rates.
Past price volatility proves that there never really was an effective long term swing producer in the oil business. No competitor in the fray can claim the swing now, so the mid-$60/B price we’re now seeing should not be taken as any sign of normalcy. The situation is far from stable. We can expect a lot more pushing and shoving in the sandbox.