Oil price to remain stuck within the shale band

Oil price to remain stuck within the shale band

The year’s end is a time of plans, forecasts and prophecies. For a few years around that time, I have also tried to say something sensible about how oil prices might develop in the future.

In December 2015, I predicted that the last year of cheap oil was ahead of us. A year later, I upheld these expectations, fleshing them out with numbers from our recently published 2017–2021 strategy.  Up to now, our forecasts have been on the mark. And indeed 2016 witnessed a drop in prices, by 19% compared with the year before. But in 2017, oil has cost 23% more than last year, its annual price having now averaged USD 54, very close to our assumptions of USD 55 per barrel in 2017–2018. So what lies ahead? Being consistent, I will reaffirm my forecast from a year ago, putting the 2018 oil price at USD 56 per barrel. If this prediction holds good, our assumption of the average oil price in 2017–2018 will materialise.

With this I could end my December entry, because for many of my readers numbers are all-important. For me numbers do matter, provided they are regarded as ranges rather than point values. The basis for looking at prices through ranges lies in the analysis of fundamental factors affecting prices in the long term, on which various risks are then superimposed. Such an approach combining the deterministic analysis of crude oil balances with risk factors makes it possible to better prepare for the coming future than betting on specific prices would ever do.

Risk factors can be divided into known (expected) and unknown risks, the latter coming as a complete surprise. Examples of known risk factors include the reaction of oil prices to another OPEC summit in June 2018 or the response of American production to a sustained increase or decrease in oil prices, defining the so-called “shale band”. The shale band is a range within which oil prices are trapped. In relation to Brent oil, it is estimated quite narrowly by some (USD 50–60 per barrel) or more widely by others (USD 45–65 per barrel). When the oil price breaks through the lower end of that range and stays there for some time, the market expects the shale output to dip lifting up the price. Conversely, when it jumps above the upper end, additional extraction capacity goes online bringing the price back within the range. An example of a completely unforeseen risk were the failures of two important oil conduits: the Keystone in the US and the Forties Pipeline System (Forties) in the United Kingdom, which occurred within a short span of time a month or so ago. The Keystone pipeline leaked an estimated 5,000 barrels of oil, as a result of which it had to be shut down for several days, followed by an 85% cut in oil flow through to the end of November. In the case of the Forties pipeline, a crack was detected during a routine inspection, necessitating its immediate shut-down with the expected repair time of two to four weeks.

I selected these examples for a reason. Oil prices in 2017 were affected by the OPEC–Russia summits and the cartel’s anticipated decisions to introduce, and then prolong, a freeze on production. In the first half of the year, the prices continued to slide, as the market realised after the first two months that maintaining the coordinated output freeze for half a year would not be enough to even keep inventories in check, let alone bring them down to the five-year average. Especially that American oil producers took advantage of a price increase at the year’s beginning (to USD 55) hedging it through futures, and were pumping happily away mindless of a resulting price decline. In the monthly window, the prices in the first half-year fell from USD 54.7 in January to USD 44.6 in June. At the end of June, OPEC and Russia extended the production freeze until the end of March 2018. Since that date, oil prices have started to edge up as the market saw that the freeze was finally clearing off the excess oil stockpiles. The process was aided by the “shale band” effect and a slowdown in US production between February and June. In the following months, US output was rising along with the prices, which however were bumping up against the upper end of the shale band at USD 60 per barrel of Brent crude. A strong growth impulse came only from the accumulation of unforeseen events indirectly or directly affecting oil supplies, such as Donald Trump’s refusing to ratify the nuclear deal and sending it to the Congress, production in Venezuela dropping by 0.5 mb/d, and other events unfolding in Libya and Nigeria. Over the past month, the faults of two key pipelines were added to the list.

The price of oil may have broken through the USD 60 threshold in the wake of these events, but I don’t expect it to stay longer at this level. The risk premium will weaken, as the effects of many risk factors will expire and the increased output will push the price down. I believe the most important driver of the risk premium in oil prices is situation in Saudi Arabia. The increased uncertainty regarding Saudi Arabia is not likely to dissipate anytime soon, significantly affecting investment risk in the country, which sits on one of the largest oil reserves, being also the cheapest to extract. If less cheap oil is produced because of investment cuts, future prices will go up as more expensive reserves will have to be tapped to meet demand. Markets are well aware of that, factoring a higher risk premium into the future oil price.

Summing up 2017, the price of oil, after the fallback in the first half of the year, has been on a steady upward trajectory since July. Three weeks into December, it topped almost USD 64, up 37% on the June level. However, it has been inflated by one-off risk factors, which will not affect its long-term trends. Over the next two years, the following fundamental factors will play a crucial role:
1. Strong increase in demand for crude oil (and liquid fuels). The increase in demand will be driven by accelerating economic growth worldwide and the (still) low oil prices. In 2017, demand is estimated to have grown by 1.8 mb/d. Unless prices rise steeply, similar increases are expected to be seen in both 2018 and 2019.
2. There is a continued overhang in global oil stocks. In OECD countries, inventories are declining, but remain above the five-year average (which itself is rising to reflect the surplus years).
3. Growth of spare production capacity, mainly in Saudi Arabia and Russia (oil reserves kept below ground, ready to be extracted at short notice). This is due to the production cuts in OPEC countries and Russia. According to estimates, in 2017 the spare production capacity has been ramped up to 3.0 mb/d (from 1.6 mb/d 2016), which implies that much more oil will flow to the market after the freeze is lifted than was cleared off it while the freeze was on. The reason is an increase in Russia’s production capacity and the fact that it is untenable to maintain any reserves of cheap oil below ground in a situation where the price is determined by the market and cost of extracting the marginal barrel.
4. Production levels in the US (tight oil) continue to respond strongly and quickly to rising prices. Now, they are growing rapidly on the back of increased capital expenditures, supported by: higher prices having been locked in through futures (hedging), an improved cost base of drilling work and equipment, and abundant access to capital (reflecting the low-rate environment). According to IHS Markit’s estimates, in September 2017 US production reached 9.5 mb/d, just below the peak output of 9.6 mb/d recorded in April 2015. In 2018, average monthly increments of 300,000 b/d are expected. However, if the WTI price stays put at USD 60 (equivalent to an increase in Brent price to USD 65), output could be stepped up by an additional 900,000 b/d within a year.
5. US oil producers and speculative investors hedge against oil price falls by buying options for future oil deliveries (oil futures). The record high sum of these transactions (net long positions) also suggests that the current price may be higher than the mere physical fundamentals of the oil market would imply.

All told, the oil supply should suffice to meet the fast growing demand in 2018 and 2019 at an average annual price below USD 60 per barrel. In the following years a price increase, if any, should only be moderate.