Since our last forecast in September, oil prices have declined sharply and unexpectedly, from a peak of near $75/b to below $50/b for WTI. A decline of $25/b sure justifies a rethink. Here we try to cut through the volatility that characterizes this market and update our thinking about fundamentals and market perceptions that will drive oil prices over our forecast horizon. As always, our thinking and rethinking are shaped by our ongoing discussions with Larry Goldstein, Director of Special Projects for the Energy Policy Research Foundation.
Oil prices began in 2018 in the $60/b-$65/b range, but markets were nervous about a lack of spare capacity and the likely impact of an embargo on Iranian exports. The threat by Trump in late summer to impose still stricter sanctions ahead of the midterm elections helped drive oil prices sharply higher, culminating in WTI hitting a peak of $76/b on October 3. Then a series of upward surprises to the supply of oil conspired to drive oil prices sharply lower, to near $50/b. That is well short of a price that would be acceptable to the Saudis, and, in advance of the recent OPEC meeting, they had already announced cuts in their production for next year. At the OPEC meeting, other members of OPEC and Russia agreed to cuts in their own production. It’s hard at this point, or at any point, to assess where oil prices will be a couple of months from now, and it’s even more difficult to assess where they’ll be a year or more from now. But, putting together our expectations for the major players—the U.S., OPEC members, and Russia—we assume that oil prices will gradually rise over the next few months toward a price for WTI in the $60/b-$65/b range in 2019.
The Iranian Embargo
Oil prices were fluctuating in a range that was narrow by oil market standards—$60/b-$65/b for WTI—earlier in 2018. The first shock was the announcement of an Iranian embargo, leading many countries to stop purchasing Iranian oil. Later, and just before the midterm elections, Trump threatened a still-stricter embargo. That drove oil prices still higher, culminating in a price of $76/b on October 3.
Supply Shock #1: Trump Prods Saudis to Increase Production
Trump was concerned about oil prices ahead of the midterm elections because of the decline in supply projected as a result of the embargo on Iranian oil exports. He convinced the Saudis to increase production, indeed to capacity, ahead of the still-stricter Iranian embargo he said would be officially implemented on November 5. The Saudis complied in September through November. This turned out to be a misreading of the markets, which, as it turned out, did not need the higher supply. Oil prices began their sharp descent, exacerbated by other surprises in supply, to the low 50s. While there has been some concern about a slowdown in global growth putting downward pressure on oil prices, projected demand for oil, based on EIA forecasts, has remained about unchanged. It’s all about supply!
Supply Shock #2: U.S. Production Surprises to the Upside
A second unexpected boost to supply came from U.S. production. There was a general view that pipeline bottlenecks in the late summer and into next year would slow the growth in U.S. production. Apparently not. The EIA reported an unexpected increase in U.S. production. More supply, lower prices.
Supply Shock #3: Trump Exempts Eight Countries from the Embargo
The third upward shock to oil supply in 2018 came when Trump, following the midterm elections, surprised not only the countries that already had stopped buying Iranian oil but the Saudis as well, by announcing a “temporary” exemption for eight countries from the Iran embargo. Before that, the markets had been pricing in a loss of about 1.5 million b/d as a result of the embargo. That had driven oil prices sharply higher. Now it looks like the impact will be about half that. Again, more projected supply (higher Iranian production and exports); further downward pressure on prices.
Reeling Back the Increase in Supply
There is no question that the Saudis wanted to see oil prices move higher, perhaps to see the markets revert to where they were in early 2018. That would take a significant reduction in production within OPEC, along with cooperation from Russia.
The Saudis got the ball rolling ahead of the just-completed OPEC meeting by a large and indeed unprecedented increase in their December and January pricing formulas, especially for the U.S. The pricing formulas announced each month tell their customers what they will have to pay when the new formulas go into effect, 45 days after they are announced. The customers than say how much oil they will want over the applicable period. The customers are said to “nominate” how much oil they want. In response to the higher-than
expected price, customers will lower nominations. The Saudis, in turn, would have to cut production to be consistent with the lower nominations from their customers. Indeed, the nominations by their customers already called for a cut in production for January by 500,000-700,000 b/d.
The OPEC Agreement and Promises from Russia
So the Saudis went into the OPEC meeting knowing that their production would be down by 500,000- 700,000 b/d beginning in January. That’s what they agreed to as part of the OPEC agreement. What the agreement did was secure promises from OPEC members and Russia to cut their production. While there was some surprise that the Russians also agreed to cut production, the agreement was eased because the Saudis agreed to make two-thirds to three-quarters of the overall cut. While the earlier production quotas adopted by OPEC in 2016 were not mentioned, the production agreed to by members of OPEC are roughly in line with those quotas, and the promised cuts by Russia roughly in line with their promised cuts at that time. OPEC gets some help from Iran and Venezuela, whose production will decline next year and hence were not included in the agreement. When all is said, and, importantly, done, the total decline in production will likely be above one million barrels per day. But the temporary exemption of the eight countries from the Iranian embargo lasts only through May and the OPEC production agreement extends through June, so uncertainty will build, and volatility increase, ahead of those dates. And it is, of course, uncertain what will follow. Markets for now seem unimpressed. They will have to see it to believe it.
Our Forecast of Oil Prices in 2019
In our recent forecast update, we of course had a much lower jumpoff for the WTI price in the fourth quarter than we had assumed in our September forecast. That’s just catching up to the data. The question for our forecast is where it will end up in 2019 to 2021. The OPEC agreement had a quite modest initial impact on WTI, raising the price by just a few dollars. Markets have to be convinced that promises are reflected in reality. And since the OPEC agreement, prices have fallen further amid the recent financial market turmoil and amid more reports of strong supply.
Supply or Demand?
I should note, consistent with the choice of markets not to take the agreement seriously, that I was struck in recent visits with clients that few thought there would be such a rebound. They were focused on the impact on the U.S. of the decline and viewed the decline in oil prices in the context of a sharp decline in non-energy commodities as consistent with a slowing in the global economy. To them, this was about demand rather than supply.
We Will Know Soon
It won’t take too long into 2019 to tell which story is right. If the promises by OPEC members and Russia are reflected in their production, which we expect will be the case, we anticipate a rebound. While oil prices will undoubtedly be volatile, we expect that the WTI price will rebound to around $60/b on average in 2019.
Coming Attractions: The New IMO Regulation
On January 1, 2020, a new IMO (International Maritime Organization) regulation is scheduled to go into effect that mandates a lower sulfur content in shipping fuel worldwide. It will increase the demand for low sulfur oil produced in the U.S. and priced in WTI, adding a premium to that price. That could be worth $5/b.
Implications for Our Forecast
Starting from the low 60s we expect in 2019, the IMO regulation is expected to lift WTI into the mid-60s or a bit higher in 2020 and 2021. That path is little changed from what had been incorporated in our previous forecast.