Every year around this time I make an oil price "forecast" for fun and have a bet with a friend. A year ago, my BAU scenario for Brent was $37 for December 2016. The current front month is $55.80. My friend wagered on $64, leaving $50.50 as the break-even point. It is time to concede defeat and examine why I did so badly?
To cut to the quick, my wag for December 2017 is $60, but we may see $80 sometime during the year. Light tight oil (LTO) production has disturbed the historic price-supply dynamic adding uncertainty to predictions.
Last year's forecast
If you read what I wrote last year, you'll find that I didn't do so terribly. There were two main reasons that my BAU forecast undershot by a considerable margin. The first is that demand was somewhat stronger than I forecast to the tune of 1 Mbpd by the 4Q of 2016. This is in part due to the data for 2015 being revised upwards by the IEA. The second was the announcement by OPEC in November that they would cut 1.2 Mbpd from January supported by Russia + other non-OPEC countries contributing a further 0.5 Mbpd in production cuts. BAU was therefore abandoned at the end of 2016 in favour of a partial capitulation.
Figure 1 Crude oil stock changes reported by the IEA are differences between supply and demand. When supply > demand, the surplus goes to storage. In red is the balance between supply and demand from last year's forecast that should be compared with what actually came to pass that is shown in Figure 2. The purple bar represents an estimate from the time the chart was made.
Figure 2 What actually came to pass in oil inventories according to the IEA. Note that 4Q 2016 remains an estimate. Also note that the 2015 data are all significantly reduced relative to Figure 1. A year ago, I used regressions on historic data to estimate future supply and demand, and since some of these data have been significantly revised, it is no surprise that my forecast was off.
On balance, I feel that the methodology I used last year was sound enough and so I repeat the exercise of linearly projecting past trends in supply and demand into the future to create a picture of how global stocks will change. However, converting this to a change in price has now become more difficult since US LTO has changed the dynamic.
2017 Demand Forecast
For many years, global demand has more or less followed linear growth. A regression has been run through the quarterly data since 2010 and the equation used to project demand into 2017.
Figure 3 Linear regressions run through quarterly demand has been used to forecast demand in 2017 (Figure 4).
Figure 4 The 2017 demand model will exceed 98 Mbpd by 4Q 2017. The purple bar represents an estimate from the time the chart was made now substituted with revised data.
2017 Crude Supply Forecast
Demand for oil increases each year as the global population and mean prosperity rises and is therefore more straightforward to forecast than supply that is subject to a myriad of economic, political and technical forces.
A regression through quarterly supply since Q2 2015 gives a totally flat line (Figure 5). The crude supply forecast for 2017 uses this and 97 Mbpd production in the 4Q of 2016 as the starting point. The projection for 2017 deducts 1.7 Mbpd production restraint from OPEC and Russia, but then adds back 250,000 bpd per quarter for increase in US LTO production as the frackers go back to work (Figure 6). This presents a picture of slowly declining supply since 2015, with inbuilt 1.7 Mbpd capacity withheld.
Figure 5 Global supply over the last 7 quarters has been totally flat. And so flat supply growth from a baseline of 97 Mbpd is used as the starting point for the 2017 supply forecast.
Figure 6 The supply model with 1.7 Mbpd capacity withheld presents a picture of a bumpy gradually falling plateau. The purple bar represents an estimate from the time the chart was made now substituted with revised data.
Note that the supply forecast does not take into account a myriad of other factors, some of which are significant such as rising production in Libya that reportedly targets 900,000 bpd by year-end, up from 363,000 bpd in September. It is difficult to see this reflected in current strong price behaviour.
Combining the supply and demand numbers from Figures 4 and 6 produces the following rather bullish picture of stock changes for 2017.
Figure 7 At face value, the return to a significant supply deficit in 2017 should be bullish for oil. However, it is market sentiment at the year-end that counts and this may be seeing a return to glut come 2018.
Price forecast for 2017
My past forecasts have been based on the relationship between supply, demand and price shown in Figures 8, 9 and 10. An explanation of this dynamic is given here. Demand is generally inelastic to price, i.e. high price will dampen demand but not by much. Supply has historically been elastic to price, i.e. high price has encouraged and produced more supply to meet demand. But in 2004, supply became inelastic where high price only prompted a small increase. This produced high price volatility as the supply and demand blades of the scissors opened and closed (see figures 9 and 10).
In recent years, I have struggled to understand what the recent evolution here meant, but have now come to realise that the dynamic has changed with the advent of N American LTO. The well ordered data from 2004 to 2009 have been supplanted by a return to elastic supply where "low price" LTO production growth has just about been sufficient to meet demand growth (Figure 8). Since 2014, the growth in LTO has been replaced by expanding supply from OPEC, especially Iran and Iraq.
Figure 8 Oil supply versus price, monthly data since Jan. 2002. The price spike of 2008 was caused by inelastic supply and rampant demand, especially from China. Subsequent to that, in the period June 11 to June 14, high price was maintained by unofficial OPEC constraint, especially from Saudi Arabia. Constraint was abandoned in 2014 resulting in the price collapse and a new equilibrium forming at around $50. Price gains made from fresh OPEC + Russia constraint will be eroded by new growth in US LTO supply.
Figure 9 The supply - demand - price dynamic approximately as it is today. See Figure 10.
Figure 10 The supply - demand - price dynamic as seen in 4Q 2017. The Supply curve is moved to the left by 0.7 Mbpd being the net reduction from OPEC cuts partly cancelled by non-OPEC supply growth. The demand curve is moved 1 Mbpd to the right to reflect demand growth. The dynamic points to a price of $70/bbl come 4Q of 2017.
The following narrative describes market behaviour as I see it unfolding in 2017:
- OPEC + Russia + other non-OPEC stick to their guns and cut 1.7 M bpd from production in January.
- Non-OPEC supply (apart from storage) cannot respond to this abrupt change (inelastic supply) and the oil price makes a strong recovery in the first half of 2017 with the price perhaps getting above $80/bbl.
- That price leads to the US frackers getting back to work, and by year-end, the total rig count exceeds 1000 units.
- The USA adds between 500,000 and 1,000,000 bpd in the course of 2017, as non-OPEC supply responds to higher price and rising demand (delayed elastic response).
- OPEC renew the production cut mid-year for a second six months amidst much wringing of hands as members observe the higher price, largely undoing their production sacrifice.
- By the end of the year, a new flood of LTO results in Brent returning to $60/bbl at the prospect of the flood continuing and on talk of OPEC returning to their market share strategy come 2018.
The supply-demand-price dynamic shown in Figure 10 points to a year-end price of about $70/bbl in 2017. However, on the back of a strong year with prices rallying to $80, I think it is likely that the bears will be back in charge come the year-end. All will depend on the actions of OPEC + Russia. If they continue with current constraint into 2018, the price will still weaken going forward as LTO production ramps up. If they abandon constraint, then the price may return to $50. My forecast of $60 therefore is a hedge between OPEC + Russia's binary choice of either continuing with or abandoning constraint.
It is quite impossible to factor in implications of the Trump presidency, Brexit and a host of elections in Europe that could see the Eurozone and the EU disintegrate.