The interaction between U.S. shale and OPEC will continue to be the dominant narrative in the oil market this year, and the opposing forces could end up trapping oil prices within a relatively narrow price band.
Market sentiment has shifted quite a bit over the past month, with the impact of the OPEC cuts sparking bullish sentiment and huge price gains in January. But the surge in U.S. shale production has decidedly broken the fever, and oil prices have retreated sharply from their highs amid fears of another downturn.
This dynamic could continue for quite a while, with prices and sentiment seesawing back and forth. Nevertheless, while OPEC and shale drillers duke it out, those too opposing forces could put lower and upper bounds on oil prices, keeping trading within a relatively tight trading range of $60 to $75 per barrel for Brent, according to a new report from the Oxford Institute for Energy Studies.
If prices creep up towards the upper end of that range, U.S. shale will accelerate, adding new supply onto the market and pulling oil prices back down. There is little room below $60 per barrel, however, as the OPEC cuts continue to keep supply off the market. Moreover, oil demand remains strong, and will continue to soak up a good chunk of the additional barrels coming onto the market. Taken together, prices will likely trade between a $60 and $70 range, with OIES forecasting an average Brent price of about $67 per barrel this year.
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Source: The Oxford Institute for Energy Studies
The argument is a variation of the “shale band” theory popularized a few years ago during the depths of the oil market downturn. According to that theory, which put more responsibility on U.S. shale specifically, prices seemed to trade between $40 and $60 for quite an extended period of time, with the unique tendencies of shale drilling throwing up resistance on those upper and lower bounds. If prices dropped to $40 per barrel and below, shale drillers went out of business and supply was curtailed, pushing prices back up. If prices flirted with $60 per barrel, a new wave of shale drilling suddenly appeared and dragged crude benchmarks back down.
That dynamic is more or less alive and well, except that OPEC has decided to raise the price floor a bit by taking 1.8 million barrels per day off of the market, a deal that has been in place for over a year. Now, the floor for Brent is more solidly at the $60 price level, rather than $40-$50 or so.
Of course, this is just a forecast, and is subject to uncertainty on many levels, some of which could force oil prices to shoot above or below the $60-$75 range. On the downside, OPEC’s exit from its production cuts could end up being more chaotic than the market currently calculates. There are a few ways this could go. First, higher production levels from Nigeria, Libya or Iraq are possible. Once output rises and compliance falls, there is less pressure on the whole group to maintain compliance. Or, the market tightens to such a degree that there is a bit of disagreement about what to do at the June meeting. A messy exit from the agreement could lead to higher-than-expected output and lower prices.
For now, it does not seem likely that OPEC will emerge as a black swan to the oil market this year. All signs – strong compliance and very clear statements of support for maintaining the cuts – point to strong cohesion at this point.
Another downside threat is U.S. shale. As widely noted, U.S. output is expected to exceed 11 mb/d this year, a year sooner than previously thought. The wave of output is expected to lead to another buildup in inventories, which keep oil prices at the lower end, especially if demand disappoints.
Which brings up another threat to prices. Demand is strong right now – the IEA puts demand growth at 1.4 mb/d, OPEC says 1.6 mb/d – which will prevent U.S. shale from crashing prices. But if demand disappoints, there is much more room for prices to fall.
The flip side is that unexpected supply disruptions could blow up the price band scenario, with a steeper-than-expected decline from Venezuela, in particular, a notable possibility. The loss of 0.5 mb/d from Venezuela would add something like $3 per barrel to the oil price averaged out for the year, OIES says. A low-probability but high-impact event of over 1 mb/d of output losses would push Brent over $70 for the year.
Then, of course, is the uncertainty over U.S. shale. Shale output is a downside risk to prices, but because the market is now pricing in huge production gains, the opposite effect could also play out. If U.S. shale undershoots in terms of output, that will likely translate into a bullish effect on oil.
But, all of those factors, individually, are mere speculation. Taken all together, OIES says that U.S. shale and OPEC could trap crude between $60 and $75 this year.
By Nick Cunningham of Oilprice.com
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