The Great Artificial Oil Price Rally
The problem with these forecasts is that the oil-price rally that began in April 2020 is mostly artificial.
When price fell from $60 in late February to -$38 two months later, it’s hard to call a return to $60 a rally. It’s really a just a recovery. Without OPEC+ withholding 8 to 10 mmb/d since April 2020, it’s doubtful the price recovery would have gotten much past $40 per barrel.
Record oil demand seems improbable since no one expects air travel to fully recover in 2021 and it accounted for about 8 mmb/d of global oil consumption in 2019.
Goldman Sach’s $80 forecast is plausible but it ignores that OPEC spare production capacity is at record levels. It reached 9.2 mmb/d in June 2020 and the March level of 8.5 mmb/d is about eleven times more than the 1.6 mmb/d the last time Brent price was at $80 in November 2018 (Figure 1).
Spare capacity is part of supply and the 8.5 mmb/d of crude oil spare capacity in Figure 1 is equivalent to about 10.5 mmb/d of total liquids. World production of 93.5 mmb/d in March would have been almost 104 mmb/d without OPEC+ constraints.
Markets know this so why would they pay $80 per barrel with an 11% surplus in OPEC’s back pocket?
Citigroup’s view is that demand for oil will explode now that Covid vaccines are available. I expect demand to improve but not even the most optimistic forecasts suggest that it will return to pre-pandemic levels any time soon.
Figure 2 shows OPEC’s latest demand forecast and EIA’s supply projection. Oil demand was more than 100 mmb/d in the final two quarters of 2019. It is about 7 mmb/d lower now in the first quarter of 2021 at 93 mmb/d. OPEC expects it may rise to 97.75 mmb/d the third quarter. It’s forecast for 99.45 mmb/d in the fourth quarter represents an upward adjustment of +1.5 mmb/d since last month’s estimate. If true, that’s a big improvement but hardly the record demand levels proclaimed by Citigroup.
The celebratory mood among analysts and journalists further ignores that current oil price is approximately the long-term average price. The CPI (consumer price index)-adjusted price of WTI since 1974 is $63.07 per barrel. The March average price was $62.33. The April 20 closing futures price was $62.44. There is nothing extraordinary about oil prices except that they have recovered from the lowest levels ever a year ago.
Oil prices cannot be whatever people think they should or might be. They are constrained by storage levels. OPEC knows this. That’s why it targets inventory because lower inventories will result in higher oil prices.
Higher price is not arbitrary or capricious. It is a cheerless and grudging matter for markets and done only when absolutely necessary.
The beauty of comparative inventory (C.I.) is that if you tell me a price that you think oil may be, I can tell you what has to happen to C.I. in order to get there. I have discussed the details of comparative inventory in a recent post.
Figure 4 shows the relationship between WTI spot price and total U.S. petroleum inventory from 2014 to the present. Two yield curves describe different periods of price formation. The red curve fit 2014 through 2016 data based on the market’s sense of supply urgency. The blue yield curve fits 2017 through present price-volume data. It reflects a lower sense of supply urgency than the 2014-2016 yield curve.
The March price-volume data point is shown in yellow with it’s $62.71 price annotated. If comparative inventory continues to decrease to the 8-year minimum, price will probably not exceed $70 per barrel. The data point by the blue arrow near the text “2018 Iran Sanction Excursion” represents the maximum price of $74.08 in July 2018.
The chart suggests that there is little possibility that WTI can get to $80 per barrel or more at any comparative inventory value unless markets re-value oil to 2014-2016 supply-urgency levels. Although that is possible, it seems unlikely given the amount of spare capacity that OPEC+ has withheld from the market since March 2020.
Figure 5 shows the relationship between Brent spot price and OECD total commercial inventories. Unlike Figure 4, I have used EIA inventory forecasts and my own Brent price projections for 2021 beyond March. The March price-volume data point is shown in yellow with it’s $65.41 price annotated.
If comparative inventory continues to decrease, as EIA expects, the August 2021 price will probably not exceed $75 per barrel. That data point is shown in the second yellow dot near the text “Aug 2021”.
There are some who dismiss comparative inventory as a “backward-looking” method. I hope that I have shown its value in making reasonably calibrated estimates of future price based on previous and projected inventory data.
Another common objection to comparative inventory is that the yield curves are not a perfect mathematical regression. They are not supposed to be. Markets consist of people and human behavior does not follow regression algorithms. Price excursions—or deviations from the yield curve–are as important as price-volume data that falls on the curves.
Excursions represent periods of price discovery. When traders perceive that something has changed, they will bid prices up or down until no one is willing to take the other side of the trade. Then, price-volume data either reverts to the yield curve or moves to a new one if the discovery process reveals a new sense of supply urgency that warrants higher prices.
That does not, of course, mean that what I have shown is correct. It does suggest plausible scenarios that do not include the kind of unconstrained price forecasts often cited in the industry press.
The main point is that there is nothing extraordinary about current price or inventory trends. Relatively tight physical supply is entirely artificial because of OPEC+ production and export constraints. That said, none of the inventory projections presented discount those constraints at all.
The important yet simple take-away is that markets are not nearly as suggestible as most analysts and investors. Markets use price as a signal to producers to drill more or fewer wells in order to ensure future supply. Markets are not like the impatient person in an elevator who repeatedly presses a button for his desired floor thinking that somehow he will get there sooner. The elevator gets the signal the first time.
Similarly, once a price signal has been sent to producers, markets do not continue pressing the button with higher prices imagining that drillers are able to drill more wells faster as a result. Recently, 152 U.S. oil company executives told the Dallas Federal Reserve Bank that they were profitable at $52 per barrel WTI price. Why should markets pay more when there is already a healthy profit margin in the $60 to $65 range?
Markets are cheap and hate to over-pay. That is the basis of price formation.
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