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A very bearish inventory report…

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Oil Spikes On Soaring U.S., Iran Tensions

Oil prices spiked on Thursday…

Arthur Berman

Arthur Berman

Arthur E. Berman is a petroleum geologist with 36 years of oil and gas industry experience. He is an expert on U.S. shale plays and…

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Oil Prices Are Where They Should Be

WTI oil prices plunged to almost $45 per barrel yesterday (Figure 1). That was a downward adjustment to where prices should be based on supply, demand and inventory fundamentals.

(Click to enlarge)

Figure 1. Oil Prices Are Testing a $45 Floor. Source: EIA, CBOE, Bloomberg and Labyrinth Consulting Services, Inc.

Analysts invent narratives to explain why things happen after we already know the answer. In this case, oil prices fell supposedly because of falling confidence that the OPEC production cuts are working, fears of increasing U.S. shale output, and weakening demand from China.

None of those factors is new nor did they seem to affect the market a few weeks ago when prices were above $53 per barrel.

The real reason that oil prices have fallen is that they were too high and needed to adjust downward. Comparative inventory analysis (Bodell,2009) suggests that the correct price for WTI right now is about $45 per barrel (Figure 2).

Prices rose from that level in November 2016 to almost $55 (black arrows in Figure 2) following announcement of OPEC production cuts. Approximately $10 of “OPEC expectation premium” was included in those higher prices. Related: OPEC’s Influence Is Fading.. But Don’t Count It Out Yet!

(Click to enlarge)

Figure 2. $45 Is The Right Price For WTI Based On Comparative Inventories. Source: EIA and Labyrinth Consulting Services, Inc.

In February and March, prices fell from more than $54 to $47 per barrel in the first deflation event shown in Figure 3. Prices then increased to more than $53 in the first half of April before falling to almost $45 per barrel this week during the April-May deflation.

(Click to enlarge)

Figure 3. Deflation of the OPEC Expectation Premium. Source EIA, Bloomberg and Labyrinth Consulting Services, Inc.

There is little doubt that the OPEC cuts are real and are working to reduce global inventories. Unrealistic expectations about how quickly markets might re-balance created an expectation premium that is now being deflated as prices adjust to where they should have been all along. Related: U.S. Oil And Gas To Contribute $1.9 Trillion To U.S. GDP By 2035

This market has been largely optimistic over the last year so it would not surprise me to see a return to $50 oil prices in the next week or so. At the same time, look for continued price volatility in the tug-of-war between revived expectation premiums and market fundamentals. Inventories will be the critical factor.

By Art Berman for Oilprice.com

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Leave a comment
  • Darrin on May 08 2017 said:
    Although he's an expert, people still view this opinion nothing more than a way to influence the stock market.
  • Disgruntled on May 08 2017 said:
    I don't like your bedtime stories, Art. Do you have any good fairy tales?
  • Norman on May 09 2017 said:
    I guess an oil writer has to use supply/demand and various charts to justify a piece but really the issue of oil price is simply dependent on when Russia will align itself with OPEC and Saudi Arabia to agree on a production level to raise prices so the all can survive (for a while as fracking is fracking them).

    Over the last 2-1/2 years as oil has gone from ~100/bbl to ~$50/bbl both Russia and Saudi Arabia have lost $500B. Another 2-1/2 years at these prices (or lower?) and they will both have lost $1T ($1,000,000,000,000).

    The above will happen unless Russia comes in to OPEC or Saudi Arabia cuts twice as much as they have to if Russia had joined in. Maybe that's what is Russia bet, that Saudi Arabia will cave. But they haven't in 2-1/2 years and probably won't. Bad for them, good for us.
  • Don Clifford on May 11 2017 said:
    There seems to be a semi-permanent price conundrum. There is a lot of production just sitting on the sidelines, waiting for any price increase, ready to jump in, and add to supply, thus limiting and even reversing the price gains. I think $55 WTI is a hard ceiling.
  • neft on May 15 2017 said:
    If you review his past posts, he is very accurate and gives logical analysis. I think he is the best of the posters on the site.

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