Oil Prices Plunge To Where They Should Be

Posted in The Petroleum Truth Report on May 5, 2017

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

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.

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.

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.

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.


20 comments on this entry


  1. Excellent analysis. Ramped up drilling isn’t going to improve the price. On a shale Forum you were being criticized as too bearish, I grow weary of defending my skeptical view, but question reserves when I analyze a sale of property. OK if you have 10 mmboe you are selling for $8/boe then someone needs to explain just what price you are really getting for light crude and what multiple are you using to convert MCF gas into oil boe? The ratio of btu content? ~8-10? Or, price ~15-25? Oil in ground should be bringing $15+. Gas? Maybe a buck. Shallow gas prospects in E. Oklahoma can’t sell into pipelines. They will transport it, but you need to have an end buyer yourself.

    So if you sell mostly gas and gas liquids, what part of that market isn’t glutted?


  2. You called this one correctly! Based on your earlier analysis, I sold the September 60 call options on the WTI futures. Currently up over $2000.


  3. Jack,

    I am gratified that you were able to use the information I provide productively.

    All the best,

    Art


  4. Hello Art,

    We keep hearing demand is going up so if the Inventory drops the PRICES will catch up soon ( hopefully by September ) Thank you , best, jerry


  5. Jerry,

    Demand has always increased but the rate of demand growth has slowed. I believe that is because demand is quite price-sensitive in a weak economy.

    2017-Demand-Growth-Has-Fallen-To-1.25-mmb-d

    I agree that falling inventories should result in higher oil prices. The question is how high thinking about my first point. In the yield curve in Figure 2, the trend crosses the y-axis at the 5-year average and the price is only $55/barrel.

    45-Is-The-Right-Price-For-WTI-OPEC-Expectation-Premium-

    That is certainly something to think about!

    All the best,

    Art


  6. I saw the headline that read “Oil prices plunge to where they should be” on OIlpro.com and said to myself, “Oh, Art Berman must have a new post up”. Can’t wait for your next look at natural gas.


  7. Bob,

    I am working on that post right now and hope to publish it later this weekend!

    Thanks for your encouragement,

    Art


  8. So according to the Comparative Inventory analysis the inventory needs to decline another 130 million barrels before a $55 WTI is supported ?

    This might take until summer 2018 unless there is major disruption in production somewhere. Meanwhile the oil industry will be in depression and social unrest and war is more likely to increase in the MENA and other oil producing nations than decrease.

    But if the over indebted global economy starts to slow down, then the inventory might start to increase instead.

    There doesn’t seem to be an easy fix to this dangerous situation.


  9. Nice work Art- Look forward to the nat gas post…


  10. Thank you Art,

    We have always heard that Oil companies must replace Oil Reserves if they are to stay in Business . Many companies are doing approx. 100,000 barrels a day which is over 3.5 Million barrels a year so they would need to be doing either Exploration of buying production ( is this correct ) or has this model changes ? Thank you very much Art , best, jerry


  11. […] Art Berman: Oil Prices Plunge To Where They Should Be […]


  12. Art,

    As many look to supply, it is in my view important to have a look on demand as well. Demand segmentation in the crude oil market has considerably changed over the last ten years. Residual fuel oil demand has declined over 5 mill bbl per day in this period. Furthermore, crude oil is replaced by natural gas liquids. Due to vast shale and Mid East supply, the NGL export market has grown from around 60 mill tons per year (or 1.5 mill bbl per day) to over 120 mill tons or 3 mill bbl per day. The total NGL market is targeting 10 mill bbl per day, which essentially doubled over the last five years.

    Demand growth from China has been mostly in NGL and not in conventional crude over the last years. It is important to mention that NGL is exempt from OPEC cuts. NGL is not considered as crude oil by OPEC. However IEA includes NGL in its calculation.

    As the giant South Pars field starts up in Iran, NGL supply will further strongly rise this year and depress demand for conventional crude further .


  13. Excellent article,

    What is your response to recent projections that U.S. production is set to grow by 1 million bpd or even more this year? Do U.S. producers really have the cash flow/access to capital to grow at that rate in a $50 environment? Not mention cost inflation from service providers, access to labor, pipeline bottlenecks etc.


  14. Adam,

    I believe that those projections are slightly aggressive. EIA’s forecast is for +0.96 mmb/d, IEA is for +0.8 mmb/d and OPEC for +0.6 mmb/d crude oil increases. EIA’s year-to-date estimate is +0.37 mmb/d. Take your pick but I imagine that IEA’s estimate is probably reasonable. I don’t see a problem with capital but frack crew availability is a real concern.

    All the best,

    Art


  15. Hi art,
    In your opinion, with this huge increase of rig counts, you think investments in rig providers as helmerich & payne could be a good choice?
    Thanks Marco


  16. Marco,

    I am not qualified to give investment advice.

    The oil-field service industry has, in general, had great losses since 2014 so substantial revenue must be directed toward re-building staff and equipment before profits are seen. It is also important to recognize that most of the increase in capital spending by E&P companies is from other people’s money and not from cash from operations. If capital markets continue to provide nearly unlimited cash, spending will continue. I see no reason to expect a change but it is a risk to consider.

    All the best,

    Art


  17. Art, what do you think of the pullback (AGAIN!) in oil from OPEC meeting yesterday…How much lower can it go…I would have thought an extension would be positive for markets…
    Oil is lower now than it was in November 2016 when the first cut was made for 6 months…This doesn’ seem logical to me…


  18. Brent,

    This is the 3rd deflation of the OPEC expectation premium so far this year.

    Third-Deflation-of-the-OPEC-Expectation-Premium-in-2017

    There has been a massive sell-off of net-long positions on oil futures.

    Net-Long-Futures-Postions-Have-Fallen-17-Since-Mid-April-2017

    Basically, the market has no confidence that OPEC cuts will make a difference because of the increased drilling by U.S. tight oil companies.

    I hope to have a detailed post on all the details soon.

    All the best,

    Art


  19. Hi Art,

    I see on your comparative inventory chart that inventories hitting the 5-year average would only produce prices of $55 per barrel. However, in your February article that looked at comparative inventory for total OECD inventories, I believe the chart showed that inventories hitting the 5 year average would equate to about $70 per barrel. I see it is Brent being used for your OECD comparative inventory chart and WTI for this one, but why such the large discrepancy?


  20. Adam,

    I was experimenting with a different mix of refined products in the graph you mentioned to test the idea that the mid-cycle price had shifted lower. Sorry for the confusion.

    Here is the correct graph.

    WTI-Is-4barrel-Over-Valued-at-49.24

    All the best,

    Art