Oil Update: Higher Lows, Lower Highs

Two key developments in the oil markets in 2016 were the OPEC agreement in November to cut production and agree on country quotas and the rebound in drilling as prices rose above the threshold for profitable fracking production. The agreement raised the spot price and near-term futures prices more than anticipated, but the rebound in drilling tempered the rise in outer months as producers hedged in the back end of the curve, and, in effect, raised the lows and lowered the highs for oil prices over the forecast period. We continue to see the oil market as in transition this year, as still-elevated inventories begin to shrink into the second half, supporting prices. Two key questions hang over the oil markets this year. The first is whether or not the November 2016 OPEC agreement to cut production quotas will be continued at the next OPEC meeting, in May. The second is whether or not Congress will pass a border tax adjustment. This commentary, like all I write on oil markets, reflects my continuing dialogue with our senior adviser, Larry  Goldstein. 

In our last commentary on oil markets [link], we said that the OPEC agreement in November 2016 to cut production did not change our views of underlying fundamentals. But, raising the floor price to around  $45 per barrel, provided an incentive for firms to increase production from fracking. Indeed, since that agreement, the rebound in fracking has been quite dramatic, sharper than we anticipated. In addition, the  

the sharp increase in drilling activity is having a modest but real impact on drilling service costs, and specifically, labor costs. This sudden increase in demand has given the service sector some pricing power that they didn’t have some months ago. But while the OPEC agreement to cut production put upward pressure on spot and near-term futures prices, the resulting rebound in fracking production will limit the rise in prices further out on the futures curve.  

The implications of these developments have been to raise the lows and lower the highs for oil prices. We see the lows now closer to $45 per barrel, compared to $35 or lower previously. That’s good news for frackers, as the new lows are near the threshold for profitable fracking. And given the higher elasticity of supply as a result of the growing share of production accounted for by fracking, we see the highs as closer to the low $60s now, relative to $70s or higher earlier. 

The oil market remains poised for a transition: Inventories remain high, but we expect them to shrink in the second half of this year toward a more sustainable level. For the moment, this overhang continues to put downward pressure on oil prices. As the overhang dissipates, oil prices are expected to rise in the second half of this year and through 2018. But this is a pattern that we have anticipated. In our last forecast, we assumed oil prices (WTI) would be $57 per barrel at the end of this year and $63 at the end of 2018, but we saw asymmetric upside risk. Our forecast for oil prices remains the same, but the quicker and sharper than-anticipated rebound in fracking has removed the asymmetric upside risk we saw in our recent forecasts. 

There are two key questions that hang over the oil markets in 2017. The first is whether or not the  November OPEC agreement to cut production quotas will be rolled over at the May OPEC meeting. The second is whether a border tax adjustment will be implemented as part of tax reform.

What Will be the Outcome of the May OPEC Meeting? 

As the November OPEC meeting approached, Saudi oil production was already scheduled to decline to accommodate the seasonal decline in domestic demand. We saw the Saudis’ motivation for the agreement at the November OPEC meeting to cut production quotas as coaxing others inside (and some outside) of  OPEC to cut their production quotas at the same time. So this was not a “real” cut for the Saudis. But the seasonal decline in demand will be over by the time of the May meeting. As a result, there is less incentive for them to roll over the November agreement. Indeed, were they to do so, the prevailing level of Saudi production would be a real cut in production relative to what otherwise would have been the case. We don’t have a strong conviction one way or another about the outcome of the May OPEC meeting, and markets will of course become more volatile as that meeting approaches. One consideration may be whether the Saudis see sufficient compliance with the November production quotas. We see about 70%  compliance within OPEC and about 30% outside OPEC. Is that “good enough” for the Saudis to be willing to roll over the agreement?  

If the agreement is not rolled over, oil prices could fall below the threshold of $45 per barrel. However, the  December price for oil is $57 and some frackers have locked that price in through hedging, so whatever happens in the markets, fracking will remain profitable through the end of the year and banks will be willing to lend to support the rebound in fracking. But a drop to or below the threshold would still be felt in terms of the drilling rig count and investment in the sector, affecting production in 2018. If the agreement is rolled over, on the other hand, there will likely be a near-term spike in oil prices. But we nevertheless see that outcome as consistent with our forecast for oil prices at the end of 2017 and 2018. 

Will a Border Tax Adjustment be Implemented as Part of Tax Reform? 

The second key question for the year is whether or not a border tax adjustment will be implemented. This proposal, like so many issues with respect to tax reform, is very contentious and will take time to be settled, so its prospects may not be clarified until later in 2017 or 2018. But the border tax adjustment is perhaps especially controversial within the oil industry because there will be winners and losers within that industry. Oil refiners who import oil will be losers. Oil producers, whether for domestic or foreign consumption, will be the winners. Overall, given that the U.S. remains a net importer of oil, oil prices will rise in the U.S. but fall globally. 

Interestingly, and to the dismay of some Republicans working on a tax plan, Trump recently leaned against the introduction of a border tax adjustment. Whether or not a border tax adjustment will be implemented remains uncertain because dropping it would cost the Treasury something like one trillion dollars over ten years, leaving a gaping shortfall in tax revenue as a consequence that would be hard to fill.  

The broader macroeconomics of a border tax adjustment is complex and leaves a lot of uncertainty about the implications for the exchange rate, the trade balance, and U.S. aggregate demand. This will be the subject of a forthcoming commentary. 

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