Oil Prices Are At A Crossroads
The oil-price rally that began a year ago is at a crossroad. In February, WTI futures fell from a 3-year high of more than $66 to less than $60 per barrel but have since recovered almost 70% of that value lost.
Was this a temporary adjustment on the long march to $70 oil or have prices reached a ceiling at around $65 per barrel?
Oil Price Recovery 2017-2018
WTI averaged about $42 per barrel in the 12 months before OPEC+ production cuts began in November 2016. Prices increased immediately to more than $50 based on false expectations that oil markets would balance quickly (Figure 1). By March 2017, concerns developed that the cuts would not work and prices fell back to pre-cut levels by June.
At about the same time, global inventories began falling and prospects for economic growth improved. WTI increased fairly consistently to more than $66 by late January 2018. That represented a 57% increase and price levels that had not been seen since December 2014.
The recent drop in oil prices was probably more because of the broader market sell-off than because of oil market factors specifically. Some analysts dismiss the sell-off as a correction to over-valued equity markets along with concerns about inflation and higher interest rates. There is also a darker perspective that slow productivity growth, increased debt and higher commodity prices in addition to those factors are already limiting economic expansion.
How Oil Traders See Things
Managed money-hedge fund long bets on oil price have fallen 125 mmb from a record high in late January (Figure 2). Long positions still outnumber short positions by 11-to-1 but the shift marks an important change in sentiment by major capital providers and that affects the way that oil traders think about the market.
Some traders view the 200-month moving average of futures prices as an important upper limit at least for the short to medium term (Figure 3). The convergence of the 200-month average and other trends suggest $55 to $65 range boundaries going forward. Many believe that oil prices are more likely to fall than to rise.
Comparative Inventory and The Direction of Oil Prices
Comparative inventory (C.I.) is the difference between current storage levels of crude oil plus a select group of refined products, and their 5-year average for the same weekly time period. Because it is a year-over-year calculation, it normalizes seasonal variations in production, consumption and refinery utilization.
It is an indicator of oil over-supply and under-supply. It shows that the U.S. over-supply of oil has ended (Figure 4). C.I. has fallen 236 mmb since April 2015 and 209 mmb since February 2017. It is now only 3 mmb above the 5-year average. The last time C.I. was at the 5-year average in late November 2014, WTI price was $72.36 per barrel.
Why is oil trading now in the low $60 range?
Figure 5 shows the same C.I. vs. price data as a cross-plot. The resulting “yield curve” (Bodell, 2009) offers a structure for organizing seemingly random variations in oil prices. The long-term yield curve (in black) has provided a useful solution for the complex market forces that relate inventory and price over the last 3 years.
Figure 5 also shows the possibility for a new 2018 yield curve (in blue) that may offer a better inventory-price solution going forward since current price is less than the long-term curve predicts. This new yield curve suggests that the mid-cycle WTI price may be $65 or lower instead of the higher price associated with the long-term curve.
This does not mean that prices will not exceed $65 per barrel. It means that $65 is the approximately correct price at the 5-year average. If C.I. becomes increasingly negative, prices should rise.
This is hypothetical and may represent a temporary phenomenon resulting from speculative pressure and bearish market sentiment. It may also indicate the market has re-priced WTI because of new market forces.
The IEA and EIA have promoted a widespread belief that U.S. tight oil production will surge in 2018 and 2019. Producers and analysts claim that efficiency and technology have lowered break-even prices substantially below current benchmark levels. The market may have decided to believe those narratives.
If higher oil prices are what producers want and need, they should be careful about what they ask investors to believe. The market is rarely generous.