OPEC’s goal was to keep a floor under current prices but the market expected the cartel to move prices higher through inventory reduction. OPEC was satisfied with greater revenues from higher prices compared to a year ago, but the market wanted deeper production cuts. OPEC takes the long view but the market is concerned with the near term. OPEC extended the cuts and the market reacted with lower prices.
Analysts have created the unfounded but widely accepted belief that OPEC has a strategy that involves a price war with U.S. tight oil producers and a play for greater market share. The cartel’s inaction before last November’s production cuts reflected an unwillingness to repeat the mistake of cutting 14 million barrels per day between 1980 and 1985 with little effect on world over-supply and financial damage for OPEC members.
OPEC’s members have disparate needs and interests. They are not unified behind any mission statement or over-arching principles except to maximize revenues and minimize losses. IEA calculated that recent production cuts earned the cartel an additional $75 million per day year-over-year in the first quarter of 2017. It also was a gift to competitors so the idea of making deeper cuts had no cost benefit.
Last week’s price plunge was the third time in 2017 that prices have adjusted downward toward the $45 per barrel level suggested by market fundamentals (Figure 1).
Figure 1. Third Deflation of the OPEC Expectation Premium in 2017. Source: EIA, Bloomberg and Labyrinth Consulting Services, Inc.
At first, OPEC did nothing after oil prices collapsed in 2014. When prices fell to $26 per barrel in early 2016, OPEC floated the idea of a production freeze and that established a floor from which prices increased to more than $50 per barrel during the first half of the year (Figure 2).
Figure 2. Oil Markets Continue Testing $55 Ceiling & $45 Floor. Source: EIA, CBOE, Bloomberg and Labyrinth Consulting Services, Inc.
In June 2016, markets lost faith in OPEC’s resolve and prices fell from $51 to below $40 per barrel. OPEC then set another price floor by announcing a tentative agreement on a production cut. When prices fell below $43 in November, another price floor was created when OPEC enacted production cuts.
The world price floor moved up almost 75 percent from $26 to $45 per barrel in just over a year. That looks like success to me. Production cuts were extended last week to reinforce the current $45 floor without helping the competition too much—not to meet market expectations of higher prices.
Oil traders understand this better than analysts and they began unwinding their long positions in February. Net long positions on WTI futures have fallen 25 percent since then but most of the sell-off has been since April 2017 (Figure 3).
Figure 3. Net Long Futures Positions Have Fallen 17 percent Since Mid-April 2017 and 25 percent Since March 2017. Source: CFTC, EIA and Labyrinth Consulting Services, Inc.
Reasons For Lower Prices
Many analysts proclaim that Brent prices will be near $65 by the end of the year. Although IEA and EIA production data suggests good OPEC compliance with the November agreement, global markets remain well supplied. OPEC shipments to its biggest customers—the U.S. and China—are more than 10 percent higher than a year ago. Production cuts are not reflected in well-supplied markets nor are global inventories falling much.
Market concerns are valid that U.S. tight oil output may cancel OPEC production cuts. Despite frack crew shortages and limits to pressure pumping equipment, 2017 well completion rates appear strong in the Bakken, Eagle Ford and Permian basin plays (Figure 4).
(Click to enlarge)
Figure 4. Increased Tight Oil Well Completion in 2017. Source: EIA and Labyrinth Consulting Services, Inc.
OECD comparative inventory for April was approximately 300 million barrels above the 5-year average. The price vs. comparative inventory yield curve suggests that Brent is as much as $7 per barrel over-valued at $52 per barrel (Figure 5). If recent withdrawal levels hold, it may take a year to reduce inventories to levels that support $65 Brent prices. On the other hand, EIA forecasts suggest relatively minor OECD inventory drawdowns through year-end and rising inventories in 2018.
Figure 5. Brent is ~ $7 over-valued at $52.31. Source: EIA STEO May 2017 and Labyrinth Consulting Services, Inc.
World production surpluses have been falling for the last year but EIA expects these to start increasing as early as May (Figure 6). Surpluses may persist through the middle of 2018 before decreasing again. Its forecast is for Brent prices to remain less than $60 per barrel through the end of 2018.
Figure 6. EIA Forecasts Production Surplus To Increase in the Second Half of 2017 Through the First Half of 2018. Source: EIA STEO May 2017 and Labyrinth Consulting Services, Inc.
Recent modeling by Macquarie Research supports this view and predicts sub-$60 Brent prices through the second quarter of 2019 (Figure 7).
Figure 7. Macquarie Forecasts Brent Prices Below $60 Through the Second Quarter of 2019. Source: Macquarie Research and Labyrinth Consulting Services, Inc.
Although OPEC cuts appear to be real, Macquarie sees U.S., Russia and Brazil production growth as bearish drivers on price. Maintaining OPEC cuts beyond the end of 2017 will be difficult and recent talk of selling half of U.S. strategic reserves potentially puts an additional 300 million barrels of oil on an already over-supplied market.
Energy = Economy
Energy is the foundation of life and oil is the primary energy source for modern civilization. Money is a call on energy and today, that means a call mostly on oil. Oil and its price, therefore, reflect the state of the economy and perhaps, the state of our civilization.
Few economists understand this. They see the economy as flows of labor and capital but rarely consider the cost or availability of energy. No wonder that they can’t figure out why the world economy has been stagnant for the last decade.
Energy investment and energy affordability are crucial because the whole system crashes without the two working more-or-less together. When oil prices got too high in 2008, the system crashed. Some people will object because the accepted narrative about the collapse is that it was because of real estate and banking. But the cost of energy was the constant underlaying those and related secular factors.
When oil prices got too high again from 2011-2014, there was no financial collapse but there was an oil-price collapse. It does not feel as cataclysmic as 2008 for those outside the oil industry because it made energy more affordable. That is a step in the right direction for growth or at least, for not losing more ground on growth.
Many think that today’s oil prices are too low. In fact, the average oil price since 1950 is $46 per barrel, in constant April 2017 dollars. Today’s $50 oil price is 40 percent higher than it was during past times of growth during the Reagan through Clinton years in the United States.
World liquids production will increase 4 million barrels per day by the end of 2018 according to EIA’s forecast (Figure 8).
Figure 8. World Production Will Increase 4 Million Barrels Per Day by End of 2018–62 Percent from the U.S., 28 percent from OPEC. Source: EIA STEO May 2017 and Labyrinth Consulting Services, Inc.
Some may doubt the forecast’s accuracy but it makes notional sense. Mostly U.S. output will keep global supply growing because capital markets and central bank policies make it possible. That will mean relatively low oil prices, a requisite for the global economy to muddle forward. Today’s under-investment in projects outside of shale plays will result in tight supply sometime in the next decade. The corresponding price spike may have grave economic consequences.
The United States Oil Fund LP ETF (NYSE:USO) fell $0.08 (-0.78%) in premarket trading Tuesday. Year-to-date, USO has declined -12.29%, versus a 8.13% rise in the benchmark S&P 500 index during the same period.
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