Almost four months ago, you saw my predictions for where oil would be at the end of the year.
Well, both main oil price benchmarks have now reached the levels I predicted. In fact, they’ve been “in the zone” for more than a week now.
My estimates published at various times since September called for West Texas Intermediate (or WTI), the benchmark set daily in New York, to trade in the $52 to $54 a barrel range by the end of 2016. Meanwhile Brent, the equivalent set in London, has been trading in the expected $54 to $56 a barrel range over the same period.
The cause has been the “Vienna Accord” to cut oil production reached by OPEC and announced on Nov. 30, and the subsequent agreements with non-OPEC oil producers, notably Russia, made last week.
Of course, the crucial point in these apparent “breakthroughs” remains whether they will last…
And how high oil prices will be in 2017…
OPEC Will Struggle to Follow Its Own Deal
WTI’s most recent high was $52.98 on Dec. 13. Brent reached $55.68 on the same day. Both are higher than at any close since July 14, 2015.
To put these numbers in perspective, WTI is up 14.1% for the most recent month and 40.7% year to date (YTD) through close on Dec. 19. Brent is better by 17.2% for the month and 47.7% YTD.
The Vienna Accord that’s largely to thank for that put a 32.5 million barrel a day limit on OPEC production and further obliged a 1.8 million barrel a day cut in production globally (1.2 million from OPEC and the remaining 600,000 from others outside the organization, half of this latter amount from Russia).
While cuts grab the headlines, Nigeria and Iran are allowed to cap at (rather than cut from) the unusually high October monthly production numbers.
Kuwait and the United Arab Emirates have already announced their cuts for January (when the “Accord” is formally set to begin). A few others from outside OPEC have announced token cuts.
However, if the Accord is to prove sustainable, a range of global and internal political matters will have to be balanced.
For example, Russian Energy Minister Alexander Novak this past weekend indicated that the 12 leading Russian production companies will create a committee to monitor production cuts. This will supposedly include state-controlled Rosneft, by far the largest oil producer in the country.
But Igor Sechin, the president of Rosneft and a political opponent of Novak, has publicly stated that the company would not cut production.
And then there are the dynamics unfolding in OPEC. I have noted before that the cartel’s actual aggregate production should be coming in closer to 33.2 million barrels a day (rather than 32.5 million), given expected excess production above monthly quotas from Iraq, Libya, and Algeria.
Venezuela, one of the original five founders of OPEC and holder of the largest reserves in the world (greater than even those of Saudi Arabia), is reeling under the worst financial collapse of any cartel member. It might be expected overproduce as well in a desperate attempt just to survive.
But Caracas has lost more than 300,000 barrels a day in production already this year because national oil company PDVSA cannot afford to maintain fields and has defaulted on its bonds. Venezuela will probably have a further production decline that goes quite beyond whatever cut it is supposed to provide under the Vienna Accord.
If this overproduction causes supply to outstrip demand, and the “balance” everybody is talking about takes longer to develop, it’s going to get much harder to ensure countries comply with the Accord.
Following two years of defending market share rather than price, there is no advantage for any producer to continue cutting production if others are not. Leaving oil in the ground simply gives up market share (and revenue) to someone else.
That’s why Saudi Arabia once again becomes crucial to the larger OPEC picture…
The Saudis Still Have a Trick Up Their Sleeve
Riyadh will cut 300,000 barrels a day, on par with Moscow. That would leave it with about 2 million barrels a day of reserves that can be easily (and quickly) extracted and put into the export flow.
Should other countries fail to comply, the Saudis will take a page from their own book. Back in the mid-1980s, when other members of OPEC simply flooded the market with volume well beyond their monthly quotas, Saudi Arabia responded by opening its own taps and driving down the price below $12 a barrel, punishing the “cheaters” with lower oil prices.
Ultimately, this becomes a psychological play, both inside and outside OPEC. To the extent that international oil traders are sold on the Accord and the market balance appears to be forming, prices will remain higher.
That’s because, as you’ve seen here before, a stable pricing dynamic prompts traders to peg contract prices at the expected cost of the next available barrel.
However, if they perceive that excessive supply is (or could be) a factor, that causes the peg to be at the expected cost of the least expensive next available barrel. And that cycle drives down prices beyond what the market itself justifies.
For the short term, I expect the arrangement hammered out in Vienna for OPEC and thereafter with others to probably hold at least through the first quarter of 2017. As such, my forward-looking forecast is what I told CNBC Asia on Monday morning (Singapore time).
WTI should be in the low $60s (i.e., $61 to $62) while Brent should be $63 to $65 a barrel at the end of the first quarter of 2017 (April 1).
Which leaves us with one final American issue…
U.S. Shale Oil Is Putting a Cap on the Oil Price
The outlier throughout the whole OPEC deal process has been U.S. production.
Because there is no American national oil producer or centralized government control of oil prices, the United States does not sit at the tables where accords like the one struck in Vienna or subsequently agreed to in places like Moscow are ironed out.
Nonetheless, prices in the mid-$60s comprise the break-even level for profitability for much of U.S. production. That excess extractable reserve does limit how high global prices can move short term.
If there is a gradual increase in production, the pricing curve is not likely to be hammered. But it will generate a pricing ceiling. So we’re not going to be seeing $75 a barrel oil anytime soon.
Instead, I see restrained rises on the horizon.
But that’s OK. Remember, it’s the floor of the pricing range that is our focus. Resistance to the downside is far more important in making a nice return on investments in the oil space than spiking ceilings.
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