The Fuse

How High Can Oil Prices Go?

by Matt Piotrowski | May 16, 2018

  • Amid OPEC cuts, oil market supply deficit to average approximately 800,000 b/d in 2018.
  • Since OPEC began cutting production in January 2017, oil prices have risen by 45%.
  • Call options for $90 and $100 active in Brent.
  • Non-OPEC supply capex down 42 percent from 2014.

Predicting triple-digit oil prices is not all that audacious nowadays. More and more market watchers see further upside for prices. Bank of America said the markets risk reaching $100 per barrel by next year, while JBC Energy wrote that the probability of “a strong bull run in crude markets—potentially even flirting with triple digits” is growing. Energy economist Phil Verleger says “we could be in store for the greatest market price disruption ever” and sees Brent possibly reaching $120 this summer. Goldman Sachs analysts estimate that Brent will average $82.50 in the coming months, with price risks “skewed to the upside.” One technical analyst told The Fuse that $100 is “in play” and may be reached just in time for the Saudi IPO in 2019. A CNBC commentator said hitting the 2008 all-time high of $147 is possible.

events

Oil markets are currently dealing with a unique set of circumstances: unplanned supply outages, OPEC manipulation, geopolitical uncertainty, limited spare capacity, rising demand, and speculative buying.

Oil markets are currently dealing with unplanned supply outages, OPEC manipulation, geopolitical uncertainty, limited spare capacity, rising demand, and speculative buying.

Now that crude oil inventories have returned to normal levels, there is little cushion against supply shocks, making all risks—known and unknown—in the oil market more precarious. Just a year ago, critics of OPEC were skeptical the cartel could “balance” the market and that its agreement would backfire by stimulating shale production, countering supply cuts. At the same time, non-OPEC producers outside of the U.S. were increasing their output at a sharp pace. After the May 2017 meeting in Vienna, when OPEC+ extended its pact by nine months, the markets sold off sharply.

Market participants now, however, are grappling with the following questions as Brent approaches $80:

  • How low will Venezuelan crude production fall?
  • How much oil will Iran sanctions take off the market?
  • Will OPEC and its non-OPEC partners continue to cut production with lower Iranian and Venezuelan volumes?
  • Do Saudi Arabia and its Gulf allies have enough spare capacity to stabilize the market?
  • At what point will demand be negatively impacted by higher prices?
  • Will shale production growth slow because of Permian bottlenecks?
  • Are speculators hesitant to short the market (bet on lower prices) as long as OPEC commits to reducing supply?

No reason to be bearish

“Is there any reason not to be bullish? No,” one energy investor told The Fuse. In a sign of market sentiment, some of the most active call options in the Brent market have been $90 for the September contract and $100 for the December contract.

Critically, the U.S. market is moving into its peak demand period, and this time of the year, inventories typically fall. Last year during the summer, U.S. crude stocks dropped by 52 million barrels, but from a much higher base of above 500 million barrels. Now, they are already 15 percent lower than year-ago levels, thanks in large part to OPEC’s cuts specifically targeting the U.S. market.

Even though shale is set to grow and the U.S. is exporting crude at high levels, the rest of non-OPEC is static despite higher oil prices.

Even though shale is set to grow and the U.S. is exporting crude at high levels, the rest of non-OPEC is static despite higher oil prices. OPEC’s latest monthly report says that 90 percent of supply growth outside the cartel this year will occur in the United States. Capital expenditures in non-OPEC grew by only two percent in 2017, and are still 42 percent below 2014. In the current scenario—with most non-OPEC countries stagnant and OPEC cutting production—the United States is the only producer seeing significant output increases. “The price is pretty good and we’re not seeing any growth outside the U.S.,” said the investor.

Assuming that Iran sanctions reduce exports (estimates range from losses of 200,000 b/d to 1 Mbd), OPEC+ continues its agreement, and demand growth meets expectations, global oil markets will see a supply deficit this year. The demand for OPEC’s crude for 2018 is 32.7 Mbd, based on the cartel’s estimates, but current production is lower at 31.9 Mbd—bringing the deficit to about 800,000 b/d.

Conditions similar to 2008, 2011

Is $100—$3.60 per gallon gasoline in the U.S.—or higher possible? Current conditions—with geopolitical unrest, unplanned supply outages, thin spare capacity, and rising demand—mirror the state of affairs in 2008 and 2011, when prices rallied into triple-digit territory. There is one big difference now, of course—shale’s massive growth. But even with the extraordinary shale increase of 1.5 Mbd this year, there is still a projected supply shortfall, setting the stage for more price gains. “Even if shale producers wanted to increase output further, they can’t because of constraints in the Permian,” said the investor.

“Barring a move by the OPEC/non-OPEC coalition, it is hard to argue how prices could weaken on a sustained basis, with price action in fact still pointing to more gains to come.”

The direction of oil prices is highly dependent on OPEC’s decision at its meeting next month and its actions the rest of the year. With Saudi Arabia signaling that it wants prices in the $80-100 range, the kingdom’s ambitious goals of its initial public offering and social spending are distorting OPEC’s strategy. It’s important to remember how and why the market got to its current situation. The push for higher oil prices has been, in large part, engineered by Saudi Arabia to pay for its domestic programs. There’s no guarantee that the Saudis will step in to increase production and make up for Iran’s lost barrels—after all, the Kingdom has not expressed concerns over the declines in Venezuela. Even though the energy minister of Saudi Arabia promises “oil market stability for the benefit of producers and consumers,” he has been coy about providing specifics. Other OPEC officials, meanwhile, have expressed complacency. As Reuters noted, based on conversations with OPEC sources: “OPEC is in no hurry to decide whether to pump more oil to make up for an expected drop in exports from Iran.”

A surge to triple digits is not guaranteed, of course. Speculators could liquidate en masse and demand growth may underperform, while the amount of Iranian oil taken offline could end up at the lower end of expectations. But for now all signs now point upward: “Barring a move by the OPEC/non-OPEC coalition, it is hard to argue how prices could weaken on a sustained basis, with price action in fact still pointing to more gains to come,” said analysts at JBC.

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