Source: Stock Photo
Demand growth for oil in 2017 will probably be on the lower end of estimates, which have been in a range of 1.2 million barrels per day on the low end, and as high as 1.6 million barrels per day on the high end.
The latest monthly report from the Organization of Petroleum Exporting Counties (OPEC) is just under the low end of the estimate, projecting the pace of oil demand growth to be on average at 1.19 barrels per day. This is under the 1.32 million barrels per day it had projected in 2016.
While the financial media continues to push the OPEC compliance narrative on the market, there are a lot of moving pieces that make this different than in the past, when OPEC engaged in similar activities; the primary one being the ongoing threat of the U.S. shale industry, and the weak compliance on the part of non-OPEC countries, which is under 50 percent as of this writing.
Oil appears to have found its ceiling in response to the production cuts, and in my view, once shale production does start to make a difference, and the expected increase in Canadian and Brazilian oil adds to global supply, oil has no place to go but down.
Even with that, I'm not factoring in the potential associated with the opening up of Federal lands by the Trump administration for exploration and development.
The oil market is dominated and being driven by those going long at this time, but the longer it takes for a break-out to the upside takes, the more nervous they'll get; especially as the market waits for oil from the U.S., Canada and Brazil to enter the market, which on the top end of my projections, will be about 900,000 barrels per day in 2017.
I think the U.S. will add 500,000 barrels per day to the market, and Brazil and Canada over 400,000 more barrels per day. If this happens before a move upward in the price of oil, it will force the longs to retreat, as the price of oil at that time will more than likely drop below $50 per barrel.
Also important to note is the talk from OPEC about possibly extending the output cut deal. If that happens, it should be considered a negative by investors, as it would signal production cuts no longer have the impact potential they had in the past.
The other issue is if there is an extension, if the non-OPEC participants in the output cuts would remain on board. It would be surprising for me to see that happen; even more so with the pace of demand growth more subdued than the market was looking for in 2016.
Direction of oil prices going forward very uncertain
While the financial press is by far on the bullish side of the price of oil in 2017, that's only because it's interpreting the production cut in the same way it has in the past; meaning it's not including the impact of U.S. shale oil.
My view is not only that this is a potential threat to the ongoing narrative, but is the key to what happens in 2017. We have yet to see U.S. oil production from shale companies make a difference to supply this year, but it's coming, as evidenced by the growing number of completed wells and rigs. We haven't seen the outcome of that yet, but we will before the first half is over.
That reason and the significant amount of supply projected to come from Canada and Brazil make me far more bearish on the price of oil in the short term.
My major question is how are those participating in the production cuts going to end it without crushing the price of oil? I know the answer appears obvious in that the expectation is the market will be rebalanced and the need for the oil taken off the market will be met from growing demand and the shrinkage of stockpiles. That will pave the way for the oil to have a limited impact on the price when it returns to the market.
That's a nice idea, but one that I no longer believe has any credibility left in it. There will be too much oil brought to market to make this the outcome.
After we stop hearing about the love affair with OPEC compliance, we'll then start hearing about the rise in supply. OPEC and the production deal are already fully priced in. We may get a little more from it if non-OPEC countries increase compliance, but there isn't much more the deal can do to support oil.
Oil prices will move mostly on inventory reports and production from the countries mentioned above. They'll push and pull on one another throughout the year, with the growth in supply surprising many to the upside, which will largely offset the impact of the production cut.
The challenge for OPEC is it has fully committed to what I consider a poor decision in initiating the production cuts. It is locked into the deal, and any failure will underscore its decreasing effect on global markets, as the U.S. is now the swing producer.
Investors should keep in mind that OPEC is doing this in response to U.S. expertise, efficiencies and increased productivity; it's being forced to take action because of U.S. supply. That hadn't happened at any meaningful level before 2014. It's not going to go away for many years.
For this year, global demand is weaker than expected, and the impact of the production cuts have reached a ceiling.
Some like Goldman Sachs (GS) believe since imports were the cause of inventory build in the U.S., it's less important because that's probably going to decline because of the cuts in production which theoretically will cut back on exports.
That assumes several things, including the possibility much of the cuts are from seasonal declines in domestic demand from OPEC members in the Middle East. They could report less production while still maintaining high levels of exports. That's important because it's exports that determine the effect the production cuts will have on the price of oil over time.
The other assumption is oil production from those outside of the agreement isn't going to have the type of impact I expect it to have. I believe Goldman Sachs is wrong here. It's also worth noting that Goldman has a much higher demand growth estimate for oil than that coming from OPEC. It's looking for an increase by 1.5 million barrels per day in 2017.
Now we're in a race between inventory shrinkage, added supply, and the pace of demand growth for oil in 2017. The price of oil throughout the year will respond primarily to these three catalysts.
My thought is production is going to end up outweighing the other two, and in that regard it's being underestimated by the market. For that reason I see those long oil being surprised, and will be forced to retreat as the price of oil is pushed down. This will provide a solid buying opportunity for those with cash on hand to take advantage of it.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.