Given record U.S. oil inventories, the fact that oil prices remain well above last year’s levels should be puzzling. It has been noted that oil company stocks have not risen at the same pace, suggesting to some that perhaps there is a bit of irrational exuberance driving current expectations. Naturally, there are numerous scenarios that would lead to a wide variety of price paths, but this blog will talk about the reasons behind expectations of continued high, and even higher, prices.
“Prices are unsustainably low” Unfortunately, this simply isn’t true but represents the recurring belief that the highest prices are the ‘norm’ even though they deviate from historical experience. Indeed, in 1982, when oil prices had dropped 25% from their all-time high, the New York Times described “the dark side of the oil glut” as the unanticipated price decline hurt efforts to develop expensive resources, including synthetic fuels, as well as efficiency efforts. In one famed false step, Chrysler’s renowned chairman, Lee Iaocca, called for a 50 cent/gallon gasoline tax, since it had downsized its largest vehicles in anticipation of ever-higher prices.
Oil Price in 2015$/barrel
“OPEC will rebalance the market” This is the strongest rationale for higher prices; not only did the OPEC/Non-OPEC agreement constitute particularly large cuts in production, it also represented a major shift in policy by Iraq, Russia and Saudi Arabia. Compliance appears high at present, certainly higher than many had anticipated (mea culpa) and cheating by smaller producers shouldn’t be enough to threaten the agreement for at least several months.
At present, OECD inventories are about 250 million barrels above normal, normal being as hard to define for oil inventories as for family structure in the U.S. The implication is that a six-month reduction of 1.2 mb/d, which seems probable, would mean that the overhang would be worked off. Of course, that ignores the non-OECD inventories, which could be as high as the OECD level, but it remains the case that if OECD inventories are dropping by more than 0.5 mb/d, traders will regard it as a bullish sign.
“The Saudis are committed to higher prices” It seems very clear that Saudi Arabia decided last year to support coordinated efforts to raise prices, and they are unlikely to change this position without good reason. Cheating by smaller producers, like Ecuador or Oman, is probably baked into expectations, but should Iraq or Russia appear to be backsliding, the Saudis could initiate a “price skirmish” to bring them back into line. If Iran seemed to be making major gains, the other producers could abandon their production guidance, but this seems unlikely in 2017. And if Nigeria and Libya are able to restore more production, that will delay market rebalancing but probably not change the Saudi policy. But if prices cross the $60 level and activity in the Permian accelerates, some adjustment is likely.
“A Trump-inspired economic boom will raise oil demand” Could be, but doubtful. Any boom should come after tax and regulatory reform, most of which will take time to be enacted and take effect. Uncertainty about government policy, and the potential for a trade war, seems more likely to reduce economic growth in the near term.
“Shale oil will underperform” The collapse of drilling in the U.S. has made some pessimistic about future production levels, although these are in the minority. Growth in production, particularly in the Permian, now looks to be robust, but whether it will be on an order to threaten oil prices, or cause OPEC to reconsider the sustainable price, will not be clear for some months.
“OPEC nations need $100 to balance their budgets” When prices first started to decline, this was noted by many analysts who cited various studies of the oil price needed to cover government budgets in various oil exporting nations. There are two reasons why this is not very reliable as an indicator of prices. First, the estimates reflect a static view of government budgets. In times of low oil prices, large-scale capital expenditures can be delayed or even canceled. Second, for much of the existence of OPEC, the oil price has been low enough that many countries did not cover their budgets. As English philosopher Mick Jagger says, “You can’t always get what you want.”
“Lower capital expenditures will tighten the market” Major oil companies have cut their upstream spending by 30-40% since prices fell in 2014, and numerous projects have been postponed or cancelled. This implies that the pipeline of new projects will be reduced to the point where, in 3-5 years, the market will tighten significantly. Of course, deceleration in costs has provided a major offset to the reduced expenditures; offshore rig rates in Northwest Europe have fallen by over 50% recently. And if upstream investment shifts to low-cost areas like Iraq and Iran, then the source of incremental oil supply will shift, but the amounts might not drop. At any rate, should the market tighten it will not affect current prices.
The upshot: as long as compliance with production guidance remains good (above 75% for OPEC members), and global inventories are declining, WTI is likely to sit in the $50-55/barrel range. Beyond six months, as the global economic situation becomes clearer and the trend in shale oil production more certain, this won’t hold. Price weakness in the second half of the year should be expected.