Crude oil prices are likely to climb close to $68 per barrel mark in 2018. We believe that oil supply will be hit due to a few geopolitical issues if they play out as we expect. Additionally, though high crude prices will be a strong incentive for the shale oil drillers to pump more, their increase is unlikely to tilt the deficit into oversupply.
- The OPEC production cut is tilting the crude oil markets to a balance
- Rise in the shale oil production is unlikely to equal the increase in demand in 2018
- The geopolitical issues can tilt the markets into a deficit
- If crude oil breaks out of $55 per barrel, a move to $68 is likely
What are the current market conditions?
OPEC oil production cuts
The November 2016 production cut by OPEC and its allies is helping the market stabilize. The US crude stockpiles have been decreasing over the past few months, which indicates that the OPEC cuts are having their desired effect, albeit slowly.
The stockpiles in the Organisation for Economic Co-operation and Development (OECD) nations is down to just under 3 billion barrels, which is roughly 171 million barrels above the 5-year average. The OPEC wants to bring the inventory levels below the 5-year average.
Reports suggest that the OPEC and its allies will extend the deal, which is set to expire in March 2018 by another 9-months. However, the oil cartel is unlikely to deepen the cuts. In the September quarter, it had produced 32.9 million barrels per day (bpd), as against 33.4 million bpd production in November 2016, prior to the production cut agreement.
In the fourth quarter of this year, the OPEC production is expected to further decline to 32.7 million bpd.
US shale oil production
The main threat to any recovery in crude oil prices is the ever-increasing production of the US shale oil drillers. US crude oil production, which averaged about 9.2 million bpd in the first quarter of this year has increased to 9.56 million bpd by the third-quarter.
The US Energy Information Administration (EIA) expects the average US crude oil production to increase to 9.9 million bpd in 2018, compared to 9.2 million bpd in 2017. That is an addition of 700,000 bpd of supply.
On the other hand, Investment bank Tudor, Pickering, Holt & Co (TPH) expects US crude oil production to reach 10.2 million barrels in 2018.
So, on an average, crude oil production by the shale oil drillers is expected to increase by 700,000 bpd to 1 million bpd.
Demand increase in 2018
The global economy is growing at a decent pace, which is expected to increase the demand for crude oil. The US EIA expects the global demand to increase by 1.6 million bpd in 2018.
Therefore, with everything else being equal, this will lead to a faster reduction in crude oil inventory and an improvement in sentiment, but not a large increase in price.
So, why do we expect crude oil prices to increase next year?
What are the events that have changed in the recent past that warrant a change in our view?
For the past two years, oil prices have not responded to geopolitical tensions because of the supply glut.
However, next year, when the markets are in a balance, any geopolitical event that can have an effect on the supply side will tilt the market to a deficit, resulting in a rally in oil prices. What are these events?
The Iran sanctions
President Donald Trump has been a critic of the deal between the US and Iran, which led to lifting of sanctions on the Islamic nation. The deal is called the Joint Comprehensive Plan of Action (JCPOA). As a result of this deal, Iran was able to resume its exports, which have skyrocketed from about 1 million bpd in 2013 to about 2.3 million bpd in September 2017.
President Trump decertified the deal on October 13 but has still not quit the deal. He wants the deal to be renegotiated, however, the remaining countries who were party to the deal and Iran are unwilling to do so.
This creates a tension between the US and Iran. Chances are that President Trump will withdraw from the deal sometime next year to fulfill his pre-election promise of ripping the deal apart.
What are the repercussions if the US quits the deal?
Presently, the EU nations are not in favor of scrapping the deal with Iran. If the US unilaterally withdraws from the deal, Iran’s exports are unlikely to have an immediate effect, until the EU decides to support it. After all, EU has been the major consumer of Iranian oil since sanctions were lifted.
However, Iran’s fields are aging. They need fresh investments to keep the oil flowing at the current rate. If the US quits the deal, it is unlikely that major oil companies, that have operations in the US will enter Iran. This can limit the capital flows to the Islamic nation’s oil sector.
As an immediate effect, the US sanctions will “put at risk a few hundred thousand barrels of Iranian exports,” Goldman Sachs wrote in a research note. However, these are only estimates and the real impact will be known only after the US withdraws from the deal. Due to the uncertainty, the markets are likely to boost prices higher, until it gets a clear picture of the effects.
Geopolitical tensions in the gulf can lead to a severe shortage of oil
The northern Iraq region – Kurdistan – is a semi-autonomous region, which recently declared Independence from Iraq. This has led to a conflict between the two. While the Iraqi forces have declared their victory in the important oil-rich region of Kirkuk, the victory is not final because the Kurdish army did not put up a fight initially to defend the oil-rich region.
However, both the Kurdish peshmerga and the Iraqi army have been trained by the US. Therefore, if the conflict is not resolved quickly, through a dialogue, it can turn bloody and lead to disruption of about 600,000 bpd of oil supply.
“Oil prices could spike a lot higher on this development because this time is different, after years of war in the region. The battle, finally, is for the oil, and no other reason. In other words, here we go,” John Kilduff, partner at energy-focused investment manager Again Capital, told CNBC.
Unless a permanent solution is reached, we expect these issues to linger on and again crop up in 2018, propping prices higher.
What does the chart forecast?
The WTI crude has been broadly trading in a range of $42 and $55. Oil has taken support close to the $42 levels four times in the past year and a half. Therefore, this is a strong support level and can be used as a stop loss for our positions.
On the upside, the zone between $50 and $55 has been a strong resistance. Oil has struggled to breakout of this zone. However, if any geopolitical event triggers a breakout above $55, a rally to $68 levels is likely, which is the minimum target objective of a breakout from the range.
How can we benefit, if crude rallies according to our expectations?
The best way to benefit from the rise in crude oil is to trade the oil futures, but due to their volatility, it is not advisable to hold it for the long-term.
The oil-based ETFs can offer an opportunity to take a position in oil. Individual energy stocks are also another means of benefitting from a rally in crude oil.
We shall soon identify the best oil-based ETF and stocks that can offer good returns in 2018.
Risk to our analysis
Our analysis is based on the assumption that the existing geopolitical issues are unlikely to be sorted out within the next year. However, a good dialogue can easily put an end to these, thereby invalidating any risk-premium to crude oil.
Also, consistent high prices above $50 can increase the US shale oil production, much higher than the currently anticipated levels. This will prevent the markets from balancing out.
Due to infighting among its members, the OPEC and its allies can opt out of the production cut deal, which will boost supply and can lead to a crash in crude oil prices.
Featured image courtesy of Shutterstock.