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The price is right

With the help of thirsty consumers and collapsing Venezuelan output, the market seems at last to have found its range

Venezuela's oil output falls steadily. The nuclear deal with Iran appears doomed. Analysts and diplomats fret that another conflict between Israel and Hezbollah is looming. Opec shows no sign of ending its cuts. Demand is strong. Non-Opec output is soaring. A global trade war seems imminent.

These are grounds for significant oil-price volatility. Yet the most telling feature of the market is its relative calm.

Since Opec and its partners started cutting in January 2017, the widest intra-month price difference has been $7.17 a barrel. In the year before, it was more than $10. In 2016, the differential average was $6.75/b; in 2015, $7.72; and in 2014, $7.17. Since the cuts, the average has been just $4.90.

Raise your glass to Opec. The group has talked often about "stabilising prices". It has done so, while engineering a price recovery, too.

Both elements are necessary, because, as demand keeps rising, upstream investment must as well—and firms need confidence to spend more. The International Energy Agency's chief, Fatih Birol, says organic decline rates are now removing about 3m barrels a day of supply each year, equivalent to the annual loss of one North Sea. So the upstream must do more. Yet the IEA expects spending in 2018 to rise by just 6%, after falling by 25% a year in 2015 and 2016. Opec's secretary-general Mohammad Barkindo says the decline in investment of recent years has been "sowing the seeds" for a future energy-supply crisis.

Stability and some price appreciation are, therefore, obviously welcome, provided they translate into new upstream commitments. But can the calm last?

Movements in inventory look supportive. After 15 months of cuts from Opec and non-Opec, the stock excess has largely evaporated. The IEA said the OECD inventory surplus to the five-year average was down to just 53m barrels in January, compared with 302m a year ago. Opec put it at 50m barrels and said in terms of days' forward cover, the stockpile—at 60—was 0.6 days below the five-year average. By now, the market may at last be in technical balance, where supply is matching demand. This rough equilibrium would help explain why Brent has found a trading range between about $64 and $66/b in March.

The kingdom is not for turning

Broad market sentiment is also behind price stability. Despite the persistent suspicions about Russia's intent, Saudi Arabia is adamant that the cuts will continue. Officials from the kingdom met hedge funds in New York recently to deliver that message. There will be no policy reversal and no early exit from the cuts. This amounts to the Saudis putting a floor in the price and the market starting to believe it will last. The kingdom doesn't want any more price weakness—indeed it's understood to want Brent to stabilise above $70/b.

Three threats to this effort are obvious. First, Opec's forecasters continue to underestimate non-Opec supply growth. The organisation's latest market report predicted a rise in 2018 of 1.66m b/d, about twice its outlook in November, but still below consensus. The Energy Information Administration says the US on its own will add 2m b/d (and non-Opec 2.5m). This is a huge range: in Opec's view, the market will be roughly balanced this year, as demand increases by about the volume non-Opec adds. In the EIA's reading, supply from non-Opec will outstrip demand by 800,000 b/d and global stocks will start rising at a rate of 420,000 b/d.

$4.90/b—Average difference between low and high intra-month Brent price since January 2017

Second, demand needs to prove itself. The forecasts from the IEA, EIA and Opec now see growth coming in a relatively narrow band, of 1.5m to 1.7m b/d. Others, like Pira and Barclays, expect consumption to increase by around 2m b/d. Synchronous economic growth around the world points to consumer strength. But Donald Trump's willingness to start a trade war have injected some uncertainty. Either way, the market won't know until after the event just how strong demand is.

The third threat is that Opec is too successful, giving investors confidence to start a new wave of final investment decisions. This isn't imminent. But as faith in $65 Brent grows, the big projects will return. Tight oil can be beaten back in periods of price softness. Not so the oil-sands, deep-water, or other long-lead-time developments. Opec might say it worries about the lack of investment in the industry, but another rush of spending on big projects would be a drag on prices indefinitely.

Supply-side tests

In the much nearer term, the market will face stress tests from the supply side—and from within Opec itself. The death of the Iran nuclear deal looks imminent. Already, says Barclays, the threat of its demise has curtailed some Iranian shipments. If Trump kills the agreement on 12 May, the market will rise in expectation that more barrels will go unsold and another period of geopolitical deterioration will begin. Likewise, the steady drop in Venezuelan output will threaten the market's equilibrium. Production was down to 1.55m b/d in January and the IEA says it could fall to under 1.4m soon. A tighter market will inevitably react to the dwindling supply of heavy oil.

The irony is that this volatility in supply and demand—represented by fast-rising tight oil, deep losses from Venezuela, escalating political risks with Iran, and wide-ranging expectations for demand—is having the effect of a price stalemate. The losses may just cancel out the supply growth; thirsty consumers might just soak up the excess. This is classical market theory at work, alongside Opec's visible hand. At $65/b, the market might have found its equilibrium price, a Goldilocks perch where producers and consumers can be happy, even while political turbulence blows in the background.

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