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Oil: An Out-of-Consensus Outlook

By Elliott H. Gue on Jul. 13, 2017

At the end of 2016, Wall Street analysts’ median forecast called for West Texas Intermediate (WTI) to average $56 per barrel in the third quarter of 2017 and for Brent to approach $60 per barrel by early 2018.

Whereas most investors cheered OPEC, Russia and a handful of other oil-producing countries’ “historic” agreement to cut output, we took a less sanguine outlook in an Alert issued on Dec. 12, 2016:

OPEC would lose credibility next year as the regulator of the global oil market. Meanwhile, WTI will range between $40 and $60 per barrel for at least the next two to three years. In the near term, we continue to expect WTI to tumble to less than $40 per barrel, once these realities become apparent.

In subsequent writings, we called for oil prices to spend much of the next two years between $45 and $55 per barrel, with spikes outside that range ultimately proving to be relatively short-lived.

This macro view has played out thus far, with sentiment on the efficacy of OPEC’s production cut beginning to sour in March, reflecting concerns about the rapid growth in US oil output in the first half of 2017. Against this backdrop, WTI tumbled to about $42 per barrel in June, before enjoying a modest oversold bounce.

OPEC’s well-telegraphed extension of its production cuts through the first quarter of 2018 resulted in additional selling pressure in May and June. The Wall Street consensus now holds that OPEC would need to deepen its production cuts through the second half of 2018 to stabilize oil prices and normalize glutted inventories. This week Goldman Sachs (NYSE: GS) even published a report warning that oil could slip below $40 without a “shock and awe” OPEC cut this summer.

Where do we stand today? Once again, our analysis leans against prevailing market sentiment.

Although WTI remains at risk of retesting last summer’s low of about $39 per barrel, we expect oil prices to find a major bottom in July or August, followed by a rally that could propel WTI to between $50 and $55 per barrel by year-end.

Market participants have focused too much of their attention on OPEC when forecasting oil prices, a bias that reflects organization’s dominance over the past 50 years. However, the emergence of short-cycle shale plays has blunted OPEC’s power to influence the oil market for a sustained period.

Before activity in prolific US shale plays took off, most non-OPEC production growth came from multi-billion-dollar developments that took years to move from the planning stages to commercial operations. In this environment, OPEC could cut its output and enjoy higher oil prices while producers spent significant time and capital pursuing complex offshore developments.

But producers in US shale plays can respond to higher prices within weeks by stepping up drilling activity and working through their backlogs of drilled wells that haven’t been completed—a form of shadow storage.

The recent cycle demonstrates how quickly (two to three months) the US energy complex can respond to higher oil prices. Meanwhile, ongoing efficiency gains from new technologies and well designs have lowered break-even rates in some US shale plays to less than $50 per barrel—an uncomfortable level for most OPEC producers over the long haul.

Consider that US oil output has surged by almost 900,000 barrels per day since October 2016, offsetting the 1.2 million barrels per day of production cuts that OPEC and its partners agreed to at the end of November. Factor in Libya increasing its oil production by 320,000 barrels per day and Nigeria upping its output by 150,000 barrels per day, and the market offset OPEC’s agreed-upon supply cuts within six months.

(Click graph to enlarge.)
Oil Output -- US Libya Nigeria

As we asserted when the deal was announced, OPEC erred in agreeing to cut production at all. Had Saudi Arabia and the organization’s other members allowed oil prices to hover around $40 per barrel, the US rig count wouldn’t have experienced as pronounced of a recovery and the country’s oil production would have stabilized around 8.4 million barrels per day—about 1 million barrels per day than the current run rate.

This approach also would have reinforced OPEC’s unwillingness to cede market share to support oil prices and underwrite shale operators’ bad behavior. Announcing a “historic” production cut merely encouraged US exploration and production companies to ramp up activity, safe in the knowledge that OPEC wants oil prices closer to $50 per barrel.

Two devastating missteps compounded this initial strategic blunder:

  • OPEC’s efforts to jawbone oil prices higher last summer by telegraphing their supply cuts to the market gave US producers a head start to ramp up activity levels four months before the agreement took effect; and
  • OPEC ramped up production in the final months of 2016, ensuring that the oil market remained glutted for the first few months of 2017 and undermining the market’s confidence in the agreement.

That said, market participants have grown too bearish on oil prices; short-term gyrations over the next month or so aside, WTI may be near a major bottom. Here’s the rationale behind this out-of-consensus call.

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