Oil prices reached a high of about $55/bbl in late February following OPEC’s November 2016 agreement to cut quotas, but are now about $10/bbl below that level despite OPEC’s extension of the quotas in late May 2017. That roughly 20% decline in oil prices from the February high is indicative of a bear market. The underlying fundamentals driving supply and demand have pushed oil prices up and down since before the November agreement and continue to do so today, but market sentiment has swung even more aggressively. We believe that markets were too bearish before the November OPEC agreement; swung to overly optimistic after the November agreement, and now are too pessimistic. First-quarter demand was weak, a normal seasonal phenomenon. Because of weaker demand and larger-than-expected supply as a result of the sharp increase in shale production in response to the higher prices after the November agreement and the increase in production by Nigeria and Libya, inventories have remained stubbornly high. But the drawdown now seems to be underway, in line with our expectation that it would become more apparent in the third quarter of this year. We continue to expect a substantial rebound in oil prices as that drawdown continues, though from a lower base and to a lower endpoint in 2018 and 2019. This commentary, like all our commentaries on oil markets, is shaped by our ongoing discussions with our senior adviser, Larry Goldstein.
OPEC Agreements Led to Sharp Swings in Sentiment and Prices
Before the November OPEC meeting, market sentiment was very bearish, with a threat that oil prices might fall into a $35-$40/bbl range without an effective agreement to cut quotas. That range is perilously close to the threshold for the profitability of many U.S. fracking firms. In addition, prices in this range would threaten the success of the upcoming Saudi Aramco IPO. After the November agreement, oil prices rose above $50/bbl. While there was initial skepticism that the agreement would hold, sentiment improved as it became clear that the agreement was holding, and oil prices stayed in a range of $50-$55/bbl through February 2017. While OPEC extended the agreement in May, indeed longer than expected, markets had expected a further cut, so sentiment became more bearish once more. Oil prices declined and continued to fall thereafter, nearing the range the agreement was intended to avoid. They’ve since edged up slightly, to about $45/bbl today.
Changing Fundamentals: More Supply and Higher Elasticity of Supply
Fracking has altered the fundamentals in the oil markets in two ways. First, rapid growth in shale production has increased global production. Second, shale producers can move more quickly than traditional producers in response to changes in oil prices. Both of these developments have contributed to the downward pressure on prices and the inability of OPEC to stem it.
The increase in supply from U.S. fracking after the sharp rise in prices beginning in December last year put downward pressure on prices, the pressure that OPEC has been unable to stem. The recent decline in prices has been reinforced by weaker first-quarter global demand, a normal seasonal phenomenon; the increase in production by Nigeria and Libya, not parties to the agreement; and the fact that production of shale has not fallen yet in response to the decline in prices because producers hedged at higher prices earlier in the year.
Fundamentals Still Support a Rebound, but from a Lower Base to a Lower Endpoint
For market sentiment to swing in a direction that supports a rebound in oil prices, markets will have to take more notice of the recent drawdown in inventories. U.S. inventories have declined in 11 out of the last 12 weeks. And the drawdown will have to continue. In addition, markets will have to see a decline in the rig count as hedging contracts run out. With demand expected to rebound after the first quarter, OPEC production flat to down, the rig count expected to decline later this year and into 2018, and inventories continuing to decline, sentiment should turn and support a rebound in oil prices in the second half of this year and into 2018.
Still, market prices cannot simply be disregarded and oil price projections, as always, carry a high degree of uncertainty, so we have taken about $5/bbl off our projected path of oil prices since our most recent forecast, released earlier this month. While we still expect a rebound in prices, indeed of a similar dimension as after the November OPEC agreement, the rebound will start from a lower base and likely have a lower endpoint. We now project that WTI will be at about $50/bbl at the end of this year and a couple of dollars higher than that at the end of 2018 and 2019.
But Risks Loom over the Horizon
We do however see important downside risk to oil in 2018, given that the current OPEC agreement runs through March 2018. At that point, OPEC might put 1.2 million barrels per day back into the market, with Saudi Arabia representing nearly half of that. It’s more likely that the OPEC agreement, led by the Saudis, will be extended further, albeit with less compliance. The new Saudi leadership has a lot riding on its success. But there is a question as to whether oil prices will hold comfortably above the $35-$40/bbl threshold that they threatened to reach leading up to the November OPEC agreement.
From Market Share-Oriented to Revenue Maximizers OPEC, and the Saudis, in particular, understood that the cuts they were proposing would cost them market share. But the goal starting in November dramatically shifted from market share to revenue. They guessed (correctly) that a small decrease in production (4%) would result in a substantially larger percent increase in price and, therefore, an increase in revenue from what otherwise would have been the case without an agreement. With the demand and supply curves very inelastic—even taking into account the higher supply elasticity of shale producers—lower supply translates into higher prices and more revenue. The higher revenue is absolutely essential—politically, socially, and economically—for Saudi Arabia. Politically, it would broaden support for the Crown Prince. Socially, it would allow higher revenue from oil exports, which would allow the Saudi leadership to provide benefits to the Saudi population, an antidote for potential social unrest, and provide resources to proceed with a plan to make Saudi Arabia less dependent on oil production in the future. So supporting prices is imperative for Saudi Arabia. But that’s not a guarantee that prices will rise to and stabilize at or above $50/bbl.