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OPEC Deal and the Future of Oil, A correction in crude is around the corner

OPEC Deal and the Future of Oil

Predicting where oil prices would go next month or next year has always been a game of hit and miss, all the more so in the past two years since the oil price crash began. Analysts forecast prices in the range US$10 to US$70 at various points in 2016, and actual prices have also had a bumpy ride, with West Texas Intermediate (WTI) crude ranging from below US$30 in January 2016 to a 17-month high briefly touching over US$55 on December 12, 2016. For 2017, the oil price predictions by major organizations and investment banks are generally not widely diverging and hovering in the US$50-$60 range, but there have been some wilder viewpoints that are phenomenally bullish or direly bearish.

After a two-year experiment with free markets, the pain of low oil prices forced the world’s biggest producers to join hands in 2016 and tackle a global supply glut. In November 2016, Saudi Arabia-led OPEC and non-member countries, primarily Russia, agreed to cut production for the first time since the global financial crisis. While the deal sent crude sailing above $50, oil markets are expected to face some strong headwinds. A growing number of analysts and investors believe the cuts will reduce stockpiles, bringing supply-and-demand balance quickly in 2017.

Although the recovery of oil price could continue this year, investors should not expect a smooth ride given that there are plenty of things that could cause quite a bit of volatility in 2017.

Analysts have a fairly wide range of opinions when it comes to where oil prices are going to head in 2017. For example, the US Energy Information Administration expects the US oil benchmark, West Texas Intermediate (WTI), to average $50.66 per barrel next year and the global benchmark, Brent, to average $51.66. Driving that outlook is the expectation that US oil production will only be modestly lower next year at 8.8 million barrels per day versus an average of 8.9 million barrels per day in 2016, which isn’t enough of a decline to make much of an impact on the market. However, what’s noteworthy about those prices is that they are below the market prices of around $52 and $55, for WTI and Brent, respectively, which suggests that the EIA sees the potential for weaker oil prices over the next year.

Other analysts are much more bullish. Bank of America, for example, sees crude jumping 46% by June 2017, hitting $69 per barrel. Fuelling that outlook is the fact that oil and gas investments are down $300 billion, or 41%, since peaking in 2014, which should lead to shrinking supplies. Further, the bank’s analysts see the persistently lower prices over the past several years driving healthy demand growth. These two factors could lead to the biggest gap between supply and demand in five years, which could push crude prices higher.

Meanwhile, Goldman Sachs seems to be taking the middle ground. It recently increased its oil price forecast by predicting that WTI crude will rise to $57.50 per barrel by the second quarter, before settling around $55 per barrel in the second half of the year. Analysts at the World Bank, likewise, have a $55 oil price forecast for 2017 due to OPEC’s moves to cut output and rebalance the oil market.

Overall, the consensus seems to be that crude will remain in the mid-$50s in 2017. Incidentally, that is similar to what analysts had forecast for oil prices in 2016. Given recent history, the odds of a quiet crude market next year appear slim.

One reason why analysts have such differing outlooks on crude prices is the uncertainty regarding OPEC’s agreements to stabilize the oil market. At the end of November 2016, OPEC members agreed to cut their total output by 1.2 million barrels per day, and non-member nations followed two weeks later by agreeing to curtail their production by 558,000 barrels per day for the first six months of the year 2017. That said, the market does not believe OPEC will follow through on those cuts, despite Saudi Arabia’s pledge to reduce its output deeper than required. Further, Russia is responsible for half of the non-member output reduction commitment, which could become problematic because its government might not be able to force oil companies to cut production. Meanwhile, even assuming full compliance, producers could quickly ramp back up as soon as the agreement expires in July, swamping the market with oil.
Meanwhile, rising oil prices could incentivize shale producers to ramp up output. EOG Resources is one of several oil companies that can rapidly boost production as prices head higher. For example, at $50 crude, EOG Resources can increase its oil production by 15% per year, with that rate accelerating to 25% annually at $60 crude. Further, it continues to refine its craft through technical innovations and efficiency gains, which could enable it to grow faster than those estimates. In fact, the company recently raised its growth outlook to those rates just one quarter after initially projecting 10% to 20% growth at $50 and $60 crude, respectively.

Likewise, other shale-focused producers have the low-cost drilling inventory and the balance sheet strength to ramp up production fairly rapidly when prices rise. Devon Energy, for example, currently plans to slowly ramp up drilling activities in 2017, going from 10 rigs at the end of 2016 to between 15 to 20 rigs by in 2017, which should deliver double-digit oil growth. That said, Devon Energy has a cash-rich balance sheet and plenty of lucrative drilling opportunities to accelerate growth in 2017, should crude run into the $60s.

The problem with these scenarios is that if too many producers ramp up next year, it could lead to a torrent of crude hitting the market in the second half which would push the oil price right back down.

However, seeing the other side of the picture brings to light the fact that although there are plenty of conditions that could keep a lid on crude prices next year, there is also an abundance of potential catalysts that could drive crude well above analysts’ estimates. For example, OPEC’s deals could have their desired effect, shale producers might remain cautious, or demand could come in higher than expected.

Besides, there is always the potential for an unexpected catalyst that could send crude prices soaring. In 2015, for example, unexpected production stoppages in Canada (due to wildfires) and in Nigeria (due to militia attacks) temporarily cut into global oil output, helping fuel a torrid run in the oil market. Similar unexpected outages could cause an explosive run in crude, especially if they come early in the year while OPEC is curbing the market’s supply. Anything from a terrorist attack on a major oil hub to a natural disaster could cause a significant supply disruption and catapult oil prices.

For the most part, analysts see a relatively calm oil market in 2017, with crude prices rising through the first half before mellowing out in the second. While that is possible, it does not seem very likely. Instead, crude prices could bounce around quite a bit as the market ebbs between fear and euphoria fuelled by rumours and changing fundamentals. Because of that, an investor’s best bet is to stick with top-tier oil stocks that have the capability to adjust as market conditions evolve.

OPEC’s Oil Market Outlook for 2017

The recent pick-up in global economic activity in combination with supportive developments in the oil-market is seen leading to higher economic growth of 3.1% in 2017, following 2.9% growth in 2016. However, some downside risks prevail as policy decisions may lead to the use of stimulus measures that may lift inflation to levels higher-than-anticipated by central banks. This, in turn, could lead to a quicker-than-expected rise in interest rates triggering numerous repercussions on economic growth in various economies, mainly in emerging markets. Despite these uncertainties, the economic landscape is expected to improve in 2017. The OECD economies are forecast to grow at 1.7%, the same level as in 2016. Russia and Brazil are forecast to grow by 0.8% and 0.4% in 2017, respectively, after two years of recession. China and India are forecast to expand at a slightly slower pace in 2017—at 6.2% and 7.1%, respectively, compared with 6.7% and 7.5% in 2016—and growth remains encouraging.
World oil demand growth was estimated at 1.24 mb/d in 2016 supported by the transportation sector, reflecting low retail prices and better-than-anticipated vehicle sales. The non-OECD, Other Asia and China saw solid-to-steady oil demand growth. In Latin America and the Middle East, oil requirements were lower than initial projections as slower economic developments and a high level of substitution dampened oil consumption. In 2017, world oil demand is projected to grow by 1.15 mb/d. In OECD, it is projected to rise in OECD Americas, flatten in Europe and continue declining in Asia Pacific. In non-OECD, improvement in economic activities is assumed to provide support to oil demand growth, particularly in Latin America and the Middle East.

Non-OPEC oil supply in 2016 contracted by 0.78 mb/d. The main contributors to this decline were the US, China, Mexico, Colombia and other OECD Europe, while growth came from Russia, Brazil, Congo and the UK. Low oil prices led to a decline of 420 tb/d in US oil production. Declines are also seen coming from Colombia and China, as well as Canadian conventional crude output.

In 2017, non-OPEC oil supply is projected to grow by 0.3 mb/d, despite initial projections in July 2016 for a contraction. This is mainly due to higher price expectations for 2017. The main contributors to non-OPEC supply growth are Brazil with 0.25 mb/d, Kazakhstan with 0.21 mb/d, and Canada with 0.17 mb/d. In contrast, Mexico, US, China, Colombia, and Azerbaijan are expected to show the main declines.

However, this forecast remains subject to a number of uncertainties, including the pace of economic growth, potential new policies and price developments. Based on the above forecasts, the demand for OPEC crude in 2017 is expected to stand at 32.6 mb/d, which is slightly higher than the 32.5 mb/d level referred to in the most recent OPEC Ministerial Conference. This, combined with the joint cooperation with a number of non-OPEC countries in adjusting production by around 0.6 mb/d, will accelerate the reduction of global inventories and bring forward the re-balancing of the oil market to the second half of 2017.

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