Hurricane Harvey was a major hit to U.S. refinery production, and the loss of refinery capacity simultaneously put upward pressure on product prices and downward pressure on crude prices. But the fundamentals will reassert themselves, and rather quickly, reflecting the resilience in the system. The most important story with respect to fundamentals is that $50 (per barrel WTI) is the new $60. This follows from the larger-than-expected supply, technological improvements allowing frackers to make money at $50, and a higher elasticity of supply that may make it difficult to see prices persistently above the mid-$50s. But Harvey is a setback for the Saudis. They need higher prices to meet revenue targets and contribute to a successful IPO. We expect oil prices to settle near current levels through year-end. While our forecast has oil prices averaging about $50 in 2018, there are asymmetric downside risks, reflecting an increase in supply we expect in 2018, mainly from the U.S. and the threat of a collapse in oil prices if discipline is not maintained and the OPEC agreement is not extended after March 2018. If OPEC can move through 2018 relatively unscathed, there is an opportunity for a modest price appreciation moving through 2019 and 2020. As always, our commentaries on oil markets are informed by ongoing discussions with Larry Goldstein, a senior adviser to MPA.
After the OPEC Agreement But Before Harvey: $50 is the new $60
Before Harvey, crude prices were in the high $40s. Frackers had reduced downside risk by hedging at $50. And fracking at that price is now profitable across the industry as a result of technological improvements that have steadily lowered costs, and hence the threshold price for profitability. Indeed, we expect a further material increase in fracking in 2018 relative to 2017, capping crude prices near $50. Prices in this range signal success for Saudi Arabia in managing and extending the agreement, now through March 2018. Without the agreement, there was a danger of a collapse in oil prices, perhaps into the $30s, which would have been a blow to Saudi Arabia with respect to both their revenue target and the success of an IPO.
Immediate Post-Harvey Markets: Gasoline Prices Spike; Crude Prices Fall
In the near term, it’s all, or mostly all, about refineries in and around Houston being impacted by Harvey. This has of course reduced the supply of products, putting upward pressure on gasoline prices, for example. At the same time, the refineries being down has reduced the demand for oil, putting downward pressure on crude prices. As expected, gasoline prices spiked dramatically, with wholesale prices immediately rising as much as 40 to 60 cents per gallon, with this being reflected a somewhat lesser extent at the pump. With refineries starting to come back, crude oil prices are starting to recover. 2.7 million barrels per day of capacity has returned (2.5 million barrels per day is still out), and thus spot product prices have started to decline as well. However, with capacity still down, product prices will remain elevated for some time.
Resilience and Quick Policy Response
The government has responded quickly. They immediately relaxed summer grade quality requirements to add flexibility to the supply chain. In addition, in an impressively quick response, the government has allowed refineries to borrow 5 million barrels from the Strategic Petroleum Reserve (SPR), and this is being pumped directly to refineries. As a result, gasoline prices have eased and crude prices are recovering somewhat.
Setback for Saudi Arabia
This is a setback for OPEC and the Saudis. For now, discipline has never been more important. And Saudi Arabia will have to extend the agreement well past their March deadline.1 What would the Saudis do in this case? Their interests are restraining supply and maintaining oil prices at a level that meets revenue targets and contributes to the potential success of the IPO. Previously, the mantra was: “We want to cut production, but we won’t go alone.” But not going alone was a strategy reflecting a Saudi focus on market share, at least within OPEC. But Saudi interests have shifted from market share to revenue maximization to meet revenue targets and contribute to the success of the potential IPO. As a result, Saudi Arabia may have to bear more of the brunt of production cuts and will have to accept whatever level of compliance there is.
Gasoline and Oil Prices in the Forecast
We already had adjusted our price of crude over the last few rounds to reflect what we see as a change in fundamentals. That story is still in place: Higher supply and lower prices, well below the high $50s or into the $60s that earlier seemed more plausible, and less chance of prices persisting at a level anywhere near $60 because of the change in supply fundamentals. So our projected price for oil in 2019 (and now 2020) remains unchanged in the low $50s. We already accounted for the changing fundamentals in recent forecasts. The temporarily higher level of gasoline prices in the near term will slow real disposable income and consumer spending, but we expect these developments to be quite modest.
We now expect an increase in supply in 2018 relative to 2017, mostly from the U.S. As a result, it will be hard for prices to break and hold above $50. Thus prices in 2018 should on average be around $50, provided the Saudis and OPEC can navigate through the challenges in 2018. After that, with demand continuing to grow, excess capacity limited, and excess inventories gone, we expect there to be upward pressure on oil prices in 2019 and 2020. However, upward pressure on prices will be limited by the higher elasticity of supply, so we project oil prices in the low $50s, about where we had them in our last forecast. But we see downside risks in 2018 and upside risks in 2019 and 2020.
The Saudi IPO: About Timing
With respect to the Saudi IPO, we expect that what is needed for success is for crude inventories to be running down, though not necessarily back to the level that earlier was hoped for. That may be enough of a signal, primarily for Asian investors. That will now take more time, relative to what the Saudis saw as a possible date. But discipline among non-Saudi participants in the agreement will be important. Only a renewal of the agreement after March next year, or a willingness of Saudi Arabia to bear the brunt of supply restraint, will prevent a collapse in oil prices.