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Oil Price Volatility Is Set To Return

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The Oil Market Is At A Major Turning Point

Refinery

Often the most important turning points in markets, and in this case the oil market, happen with a whimper rather than a bang. The ongoing crash in the oil market is mostly associated with OPEC’s fateful 2014 Thanksgiving Day decision to abstain from a production cut, thus sending the oil prices tumbling down by close to 10 percent in a single day. This was perhaps the price turning point, however this wasn’t the fundamental turning point, the latter goes back to August 2013.

First, let’s set the stage. For decades, the oil market operated under a simple formula:

(Global oil demand) – (non-OPEC supply) = OPEC production level (Call on OPEC)

Put simply, OPEC acted as a safety valve, it released the valve when there was growing demand or a major supply outage, and restrained it during periods of sudden demand weakness such as global recessions. The formula worked, because for the most part, non-OPEC supply wasn’t growing sufficiently to meet demand growth, this in turn gave OPEC the upper hand in dictating a given level of global oil supply.

The emergence of shale oil in the United States as a viable supply source earlier this decade changed this stable relationship.

(Click to enlarge)

As can be seen from the above, Non-OPEC supply held at a around 52.5m barrels for the three years prior to the oil crash, from 2010 to 2012. Then something happened. Non-OPEC supply leaped forward by 2m barrels in 2013 and by another 2.5m barrels in 2014. This begets an important question: Why didn’t oil prices tumble in 2013? Why did it take until late 2014 for the market to take note of this sizable underlying shift in non-OPEC supply?

The answer can be found here:

(Click to enlarge) Related: Can OPEC Resist The Temptation To Cheat?

This associated graph details YoY growth in monthly global oil demand, monthly OPEC and non-OPEC supply. Analyzing this data yields some fascinating results, and offers potential insight on where the oil market could be heading.

The first 12 months of the graph (Year 2013) demonstrates that non-OPEC supply mostly lagged global demand growth until August 2013, with the exception of two months, May and June. In August 2013, something changed, non-OPEC supply growth exceeded global demand growth and never looked back for 22 months straight. A highly unusual occurrence, yet, this fundamental change in the supply-demand relationship went largely undetected due to production declines at OPEC at the time (mostly due to production declines in Libya and Iran). This fragile balance finally broke down in September 2014, once OPEC resumed its production growth. This on top of much sustained non-OPEC production growth finally overwhelming global demand growth. This can be seen from the black line (global supply) breaking decisively above the purple line (global demand).

Looking at this, it is safe to conclude that oil prices were artificially maintained at the $100 level for most of 2013 and 2014 due to involuntary production declines at OPEC masking the extent of the imbalance between price sensitive non-OPEC supply and demand growth.

Non-OPEC supply stalls

After spending 22 months running ahead of demand growth, something happened in June 2015, Non-OPEC supply lagged global demand growth and has done so ever since. This fundamental shift has gone largely unnoticed due to a material increase in OPEC’s production in 2015 and 2016. What’s key to understand is that the majority of the increase in OPEC’s production was largely a one-off event.

During 2015 and 2016, OPEC raised its production by 2.12m barrels from 30.4m to 32.52m (as per EIA data). 84 percent of the increase or 1.77m barrels came from only two countries: Iraq and Iran. The exceptional increase in Iraqi production was due to large IOC investments undertaken before the crash (2011 to 2014) maturing in 2015. Meanwhile, the increase in Iranian production was due to the removal of the nuclear sanctions in January 2016.

The increase in Iranian production last year was especially significant in masking the extent of non-OPEC declines. In 2016, OPEC production increased by 890K barrels, 690K barrels of the increase came from Iran. Absent an increase in Iranian production in 2016, the oil market would have been materially undersupplied. Related: Oil Prices Wait And Watch For OPEC’s Next Move

What’s next?

Due to the factors discussed above, the market has been under the impression that $50 oil is business as usual, just as the market was deceived into believing that $100 a barrel was business as usual in 2013, and for most of 2014. To truly gauge the oil market ability to balance at a given oil price, one must adjust for geopolitical changes in OPEC’s supply. Undertaking this exercise clearly indicates that a triple digit oil price is not sustainable due to its negative impact on demand growth and its overstimulating impact on Non-OPEC supply. Meanwhile, it is also clear that current oil prices are too low as evident from demand growth exceeding non-OPEC supply for the last 20 months and counting.

For current prices to sustain, OPEC must continue to fill the growing gap between non-OPEC supply and global demand growth. In light of the one-off OPEC supply factors that have taken place over the last two years - the ongoing OPEC cut not withstanding - its questionable that OPEC will be able to grow its production at the same brisk rate it did in 2015 and 2016 for any length of time (OPEC capacity growth will be the topic of my next article.)

With OPEC holding its production flat, a major turn in oil prices appears imminent, and could potentially carry prices to the $60-$70 range once the market takes notice of non-OPEC’s supply inability to meet demand growth at current prices.

By Nawar Alsaadi for Oilprice.com

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Leave a comment
  • J P DeCaen on March 19 2017 said:
    Do these rosy predictions take into account the large amount of oil in inventory? The basics are simple, so why do people keep forgetting?
  • adec on March 19 2017 said:
    Hope to see more articles from the author.
  • Santhosh on March 19 2017 said:
    One aspect that the author has not considered is the ability of shale to crank up the supply by a million or odd barrels. This will have a dampening effect on any uptick in oil prices. This will continue till the ability of shale to fill in the demand supply gap is exhausted. To understand the likely gap one has to see the demand growth in light of the technological advances in the transport sector over the next five to ten years. I think such a scenario has been adequately studied in the Goldman Sach and Bloomberg reports. Plus the high inventories already available have to be worked off. So oil going high is highly unlikely unless there is major black swan event..
  • Greg Joshner on March 20 2017 said:
    Very interesting analysis and quite amazing to see. However, I don't agree with the concluding remarks "With OPEC holding its production flat, a major turn in oil prices appears imminent, and could potentially carry prices to the $60-$70 range once the market takes notice of non-OPEC’s supply inability to meet demand growth at current prices." - this is counter the fact that US rig-count is up, that IEA projects a decline in demand growth and any effect it may have is buffered by overflowing inventories.

    I know that people think the IEA got demand projections wrong. I know that you believe that non-OPEC supplies can't keep pace with demand growth. And I know that people like to ignore inventories.

    But neither I nor oil futures can see how all this will end in a raising oil price.

    Keep in mind: Lower gas prices have successfully been eating into the coal market (which has been hurting a lot lately) while higher oil prices will accelerate the transition to renewable energy (wind+solar+batteries). This substitution - which was not technically/financially viable in 2014 or earlier but it is certainly viable today - may not be sudden or immediate but also won't be undone once it happened.

    So here is how I would have worded the last sentence:

    "With OPEC holding its production flat, a major turn in oil prices appears imminent, and could potentially start an oil price war once the market a) takes notice of non-OPEC’s supply ability to meet demand growth at current prices b) understands that oil prices above $50 will lead to oil market destruction through lasting substitution. This could lead to a "everything must go" fire sale of oil.
  • Naomi on March 21 2017 said:
    Earth to King Saud. You breed em. You feed em.
  • Doug on March 25 2017 said:
    A lot of the comments have the usual US focused analysis which misses the biggest point of the article.. US production increases will not make up for the other Non OPEC production decline..
    OPEC 32mbopd
    Russia 12mbopd
    US 12mbopd
    Other Non OPEC 40mbopd .. & declining.
  • Citizen Sane on March 25 2017 said:
    The author is conveniently ignoring the fact that, despite OPEC cots and mathematical calculations that show oil inventories should be decreasing, they are continuing to increase. This indicates massive manipulation of oil production, shipping and storage by the many opaque producers in the world which indicates that there is a lot more oil available than what the transparent producers are reporting. I would look for a competitive price/production war in the coming weeks as Saudi leaders realize that their noble cuts are lining the coffers of other nations.
  • Citizen Sane on March 25 2017 said:
    The author is conveniently ignoring the fact that, despite OPEC cots and mathematical calculations that show oil inventories should be decreasing, they are continuing to increase. This indicates massive manipulation of oil production, shipping and storage by the many opaque producers in the world which indicates that there is a lot more oil available than what the transparent producers are reporting. I would look for a competitive price/production war in the coming weeks as Saudi leaders realize that their noble cuts are lining the coffers of other nations.

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