Higher oil and fuel prices, increased volatility on tap for rest of 2018
Oil prices will continue to face upward pressure, and—perhaps even more importantly—oil prices will become even more sensitive to geopolitical disruptions.
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As expected, oil markets continued to tighten over the course of the first quarter, and there is every reason to expect that markets will remain tight through the rest of the year. Consequently, oil prices will continue to face upward pressure, and—perhaps even more importantly—oil prices will become even more sensitive to geopolitical disruptions.
Strong global demand
Strong global demand has underpinned the nearly 60% oil price increase that has occurred since last summer. Over the course of last year, global oil consumption grew by 1.8%, and demand was 2.1% higher in the first quarter of 2018 than it was in the first quarter of 2017.
A continued strengthening of the global economy should correlate to a slight acceleration in global oil consumption through the end of the year. While world GDP grew by a healthy rate of 3.7% in 2017, the consensus outlook among 10 investment banks is for the world economy to grow by 4.0% this year.
Over the first quarter, we have already seen strong economic growth in the U.S., China and Japan, which are the top three oil-consuming economies. Through the rest of the year, oil consumption should continue to be strong, with year-over-year growth between 1.6% and 1.8%. With global oil liquids consumption at just under 100 million barrels per day, this equates to an increase of between 1.6 million barrels and 1.8 million barrels per day.
Global supply: The glut is gone
In May 2017, OECD stocks hovered around 275 million barrels above the five-year average. By press time, this surplus will most likely have disappeared all together, as the glut has been contracting at a rate of around 800,000 barrels per day. Not coincidentally, oil production from the “OPEC 14” is down by approximately 750,000 barrels per day over this period.
What remains to be seen is whether OPEC can lift production to the degree necessary to ease upward pressure once they decide to uncork the taps. Production statistics suggest that OPEC may not be capable of bringing enough new oil to the market to account for growing global demand in light of Venezuela’s production crisis.
While Saudi Arabia has led the way with production cuts, Saudi volumes produced in April are only around 500,000 barrels per day lower than the kingdom’s maximum sustainable production rate. While they remain the world’s pivot producer, it does not appear that they alone could stem the stock withdrawals.
The United Arab Emirates (UAE) could most likely add another 100,000 barrels per day to OPEC production, but increasing to this level would bring them to a production level above which they were only able to maintain for a brief period once before.
Other than Saudi Arabia and the UAE, the only other OPEC country that appears capable of lifting output to a meaningful degree is Kuwait, which appears poised to add an additional 100,000 barrels per day to the cartel’s total output. Together, these three countries appear capable of bringing an additional 700,000 barrels per day to the system.
A whole host of other OPEC producers have encountered production challenges over the last six months. Libya and Nigeria are both exempt from OPEC production cut quotas, but production from both countries has plateaued since the summer of 2017.
Similarly, while Iraq is bound to production quotas, it appears that the country is producing at a maximum rate. It might be possible for Iraq to lift production, but we should not count on Iraq being able to add more than 50,000 barrels per day to OPEC production at this point. Adding Iraq’s potential contribution to Saudi Arabia, the UAE, and Kuwait brings the total OPEC potential increase up to 750,000 barrels per day.
Under the OPEC quotas, Iran could produce more than 4 million barrels per day and still not violate the OPEC production quota. The problem is that Iran’s oil production has been flat for the last 12 months. This is especially telling considering that the country is in desperate need of petrodollars to ease a recent run on the rial, which has lost half of its value in recent months.
While the possibility of Iran lifting oil production appears to be remote, the risk that oil sanctions will be re-imposed is not. The nuclear deal that eliminated sanctions is set to sunset in May, so unless a new agreement is hammered out in the next few weeks we should expect production to fall to some degree.
Russia could probably lift production by as much as 150,000 barrels per day, and adding this to the 750,000 barrels per day from OPEC, we might expect the volume that could be brought back online to be around 900,000 barrels per day.
This would be more than sufficient to cover the current stock draw of 800,000 barrels per day, but from this volume we need to back out some amount to account for Venezuela’s production crisis.
Over the last year, Venezuelan production has fallen by 500,000 barrels per day, and 400,000 of the loss has come in the last six months alone. Even if Venezuela is able to significantly arrest this slide, it wouldn’t take much to erase the 100,000 barrel per day cushion.
While the outlook for U.S. oil production remains quite bright, we must recognize that OECD stocks were drawn down over the last 12 months despite U.S. production increasing by 1.6 million barrels per day. In short, if U.S. production continues to surge, it could be sufficient to cover the expected increase in global demand.
If the United States covers the incremental new oil demand, we’re left with the problem that stocks have been drawn down at a rate of 800,000 barrels per day, and it doesn’t appear that OPEC and Russia combined can lift production by that amount unless the decline in Venezuelan production is arrested.
Tight markets: Rising prices and increased volatility
Oil prices have been climbing in a more-or-less steady state since last summer, and while recent geopolitical events have certainly had an impact on prices, it would be wrong to conclude that oil prices are being overinflated by a risk premium. The fact remains that oil supply has fallen well short of demand, and the analysis above suggests that this will remain the case.
At the end of last year when formulating an oil and fuel price outlook for LM’s annual rate outlook, I explained that the fundamentals supported a continuation of the upward trend in prices. At the time, a barrel of oil would fetch around $58, and I predicted that by the end of the first half, prices would rise 20% to just under $70. At the time of writing, West Texas Intermediate is trading at $68 per barrel.
If the global economy yields to the consensus forecast, oil prices will continue to climb through the third and fourth quarter, and we may see $80 oil by the end of the year.
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