Our story about oil markets is little changed, though our oil price projections have risen about $5/bbl for the end of this year and in the next two years between our first commentary on oil prices in January 2016 (link) and now. The November 2016 OPEC contributed to the firmer price, and, as we have emphasized, supported higher lows, while the quicker and sharper-than-anticipated rebound in production underway has contributed to lower highs, as has the move of frackers to lock in prices further out the curve. That, in turn, helps explain the current backwardation in the futures curve. The Saudi Aramco IPO, likely in early 2018, hangs over the June OPEC meeting. It is not easy to project the outcome, but we can at least say that the IPO soon after will encourage the Saudis to roll over the November agreement to support oil prices, reduce the risk of a sharp decline, and allow a narrowing of the still-prevailing inventory overhang in the second half of this year. This commentary, like all my commentaries on oil markets, has been shaped by ongoing discussions with our Senior Adviser, Larry Goldstein.
Steady Story and Modest Rise in Oil Price Projections
Frankly, Larry Goldstein has been on a roll, and we are just benefiting from that in the steadiness of our story and in our oil price projections, noting, however, that we are ultimately responsible for our forecast. Our oil price projections for Q4 of this year and next rose about $5/bbl in June last year, and have remained within a few dollars of the June forecast since. And we are again keeping unchanged our oil prices projections in this forecast round: still $59/bbl at the end of this year and $63/bbl in 2018:Q4 and 2019:Q4.
A large inventory overhang was putting downward pressure on oil prices, contributing to a period of prices in the low $30s in the first quarter of 2016. While oil prices had rebounded to the mid-$40s before the OPEC decision, the agreed production quotas contributed to a rise to above the critical near-$50 threshold for profitable fracking.
Fracking and the Short-Run Elasticity of Supply
The growing importance of fracking has changed price dynamics in oil markets. The central story before that was very low short-run elasticities of both supply and demand, which gave rise to sharp swings with even modest changes in supply or demand (link). Today, the short-run elasticity is materially higher, given the ease with which frackers can stop or resume drilling in response to changes in oil prices. Fracking uses dramatically different technology than does offshore drilling by the majors, allowing a quicker supply response to changes in oil prices, especially when they fall below or rise above the threshold for profitable drilling. The potential for learning and improvements in the new fracking technology, along with the incentive to do so provided by the decline in oil prices, has been increasing the ability of frackers to maintain profitability even as oil prices declined. And oil price dynamics will be sensitive to both the size of the fracking industry and advances in technology.
Higher Lows and Lower Highs Contribute to Slight Backwardation
The shape of the futures curve has changed a lot since our first commentary in 2016, from strong contango to backwardation. The very sharp contango at that time was not surprising because oil prices had fallen into the $30s, and even below, earlier in the year. That’s way below what most saw as a normal level in the medium to longer term. The higher lows that followed the November OPEC decision boosted the short end, while the rebound in production, larger than we anticipated, is capping the futures prices out on the curve. In addition, bankers, who basically control the opportunities for frackers to drill, are encouraging frackers to hedge by locking in prices out on the curve. We expect the curve to flatten around a price, perhaps in the low $60s, that may be the new normal, but we say that with appropriate caution. With more confidence, we say we do not expect to see prices above $75/bbl, and certainly nowhere near $100/bbl for some time, way past our forecast horizon, if ever. Fracking technology, increased use of natural gas, and cleaner energy sources are all weighing on demand for oil.
The Aramco IPO Hangs over the June OPEC Meeting
Up to 5% of Saudi Aramco will be listed in an IPO, most likely in early 2018. Significantly, the IPO will come after the June 2017 OPEC meeting. There is a challenge in valuing the company, perhaps much more so than is typically the case with IPOs. In any case, it appears that the price set by underwriters will be sharply lower than the earlier optimistic hopes of the Saudis. All the more reason to keep in place an oil market conducive to prices at least above $40/bbl, and better yet above $50/bbl, a price that also supports the budget of the Saudis.
So the IPO hangs over the June OPEC meeting and decisions. We don’t want to overstate the importance of the IPO to whether the Saudis seek a rollover of the November cut in production quotas, but this consideration moves our subjective probability of a rollover from near 50/50 to modestly above that.
A rollover would be in the interest of the Saudis because it would contribute to a higher valuation for the IPO by propping up and stabilizing prices and, by facilitating a decline in inventory stocks, would reduce the risk of a material decline in oil prices.
Compliance and the Saudi Decision
The Saudis are not prepared to tip their hand in advance of the meeting. Doing so might encourage less compliance than there is now. The Saudi mantra remains: “We will cut production, but not alone.” The Saudis, of course, will always bear a disproportionate burden for any cuts in production, but the impending IPO may make them somewhat more tolerant of the failure of many producers to meet their agreed-upon quotas, as long as the projected oil supply from OPEC and non-OPEC participants in the agreement, taking account of compliance, contributes to maintaining a price near $50/bbl and, especially, provides insurance against the price falling below $40/bbl. Still, frankly, the compliance seems better perhaps than anticipated. Likely good enough for a rollover.