Sentiment toward the oil market has been volatile this year. The number of oil contracts purchased by bullish investors started ticking upward after the November agreement between OPEC (Organization of the Petroleum Exporting Countries) members and non-member (NOPEC) producers, and reached an all-time high in April. But this trend reversed direction when the inventories targeted by the production cuts remained stubbornly high.
So what happened? Were the producers cheating and producing more than agreed? Was the global economy faltering?
First, some background. 2016 was a particularly volatile year for oil production. The Chinese stimulus in the first quarter and the US stimulus of December 2015 started a global pickup in activity in September ahead of the US elections. These actions encouraged a pickup in global demand for oil. Meanwhile, global supply disruptions reached a high of 4.0 million barrels a day (bpd). For some perspective, the change in global supply/demand balance from 2014 –15 was 3.0 million bpd, and this caused the price to plummet from $114 to $37 – so 4.0 million bpd is indeed significant.
While a sustained disruption of that magnitude would have helped to return inventories to normal levels, it would have also fuelled more terrorist recruiting in Libya and further recession in Nigeria.
OPEC takes action
The Saudis and Russians led an effort to spread the needed cuts across a wider group of nations to make room for the returning supply. The agreement was signed in November 2016 and in June was extended to March 2018.
The OPEC/NOPEC agreement cut production by 1.8 million bpd with shared cuts across 24 nations. The supply disruptions have come down from 4.0 million to 1.5 million bpd – adding 2.5 million to global production. We estimate the global oil balance is in a shortfall of 400,000 bpd. That is enough to reduce inventories to 2014 levels by early 2018.
This regeneration of OPEC’s power – taking its market share from 40% to 60% when including its new oil-producing allies – was not lost on speculators. By February, the bullish sentiment was extreme. Momentum strategies piled into oil as prices bounced off the previous year’s low. Then came the reckoning: inventories stayed high. We see three reasons for this.
First, from January to March, producers managed their production down to the agreed levels, delaying inventory improvement. Second, the US government’s planned Strategic Petroleum Reserve sales – which funded two legislative initiatives during President Obama’s tenure – ended up adding 13 million barrels to commercial inventories. And third, the US winter was considerably warmer than normal. This meant that there was less demand for heating fuel than usual – effectively neutralising 20 days of the OPEC cuts.
Inventory reduction begins…
Inventory reduction has now begun, however. Towards the end of July, a 4.4 million barrel fall in US gasoline inventories emphasised the fact that the market is on track for a reduction back to 2014 levels. This is particularly impressive as very high margins mean that refineries are producing at near-maximum capacity. The gasoline data followed several weeks of inventory declines in a combined crude, gasoline and diesel stockpile.
Current analyst estimates for Brent/West Texas Intermediate crude are in the very wide range of $37–75 a barrel for 2018. Our base case is for $45–55, assuming stable economic improvement and no change in the effectiveness of the OPEC/NOPEC agreement. We do not see Ecuador’s recent exit from the agreement as a threat because of the powerful economics at work. Most rational oil ministers would take small cuts in production in return for selling 95% of their oil at prices $20 higher than without the cuts.
...but risks remain
There are risks to this base case from Venezuela. Internal strife in the country could put its 1.9 million barrels of production at risk, but any serious disruption could be met with a relaxation of the OPEC/NOPEC agreement, limiting oil-price upside that would only encourage more US production. The other major risk is an economic slowdown that reduces demand while inventories are still relatively high. This could send prices back to the $30–40 level, but we do not see evidence of such a slowdown.
Overall, though, the world’s oil markets appear to be trading back on fundamentals, now that a stronger cartel is in charge of 60% of global production. Financial speculators have left the market, at least for now, improving the probability of a more stable price environment. There are uncertainties ahead, but at present, there appears to be slightly more upside than downside.