Crude oil prices have been volatile this year. West Texas Intermediate (WTI) prices, for example, fell by close to 21% from early January to late June, and since then they have bounced by 18%. These moves have been within a USD 40-60 per barrel trading range, which is quite narrow compared with previous intra-year swings (see Exhibit 1 below).
Exhibit 1: A new era for crude oil supply with OPEC being replaced by the US shale complex as the swing producer in the oil market
Source: BNP Paribas Asset Management, as of 17/10/2017
We have entered a new era for crude oil supply
The main reason behind this tighter trading range is that we have entered a new era for crude oil supply: the continued rapid expansion of US shale production. This supply shock has overwhelmed OPEC’s efforts to cut supply and only in the last few months prices have marched higher again, helped by stronger demand growth. But we expect the upside to be limited as we anticipate growth in the supply of US shale production to cap price gains over the next 6-12 months.
Supply – US shale is key
Technological advances in the extraction of US shale oil are defining the new era for crude oil supply and prices. US shale production has increased rapidly since 2012 and it has played a major role this year. After falling by 12% from mid-2015 to mid-2016, US crude production (of which 48% was extracted by shale producers according to the IEA in 2016) has bounced to close to the mid-2015 highs.
WTI prices rose in November 2016 following OPEC’s announcement of production cuts, the first such cut in eight years. However, the rally proved short-lived and WTI prices fell sharply in the first half of 2017, suggesting that the increase in US supply more than offset the prospect of OPEC cuts (Exhibit 2). In the last few months prices have bounced back, but in our view this reflects stronger demand growth and falling inventories, especially in the US where stocks are at multi-year highs.
Exhibit 2: US crude production up, WTI prices down year-to-date
Innovation is leading to lower costs in shale production
One of the key characteristics of US shale production is that efficiency gains have materially reduced the costs of producing crude. According to Barclays research, for example, close to 80% of shale producers operated at a cost below USD 60 per barrel in late 2016. Furthermore, their research suggests that such costs of production have come down further recently. In other words, innovations in the extraction of crude oil from shale fields are still ongoing. This has two clear implications for prices. First, they are likely to stay at lower levels than before the shale boom. Second, it means that shale production can respond rapidly when demand picks up, i.e. US crude supply is much more elastic than in the past.
Despite lower crude oil prices due to shale production, there is also a negative environmental impact of the oil shale industry
Among the negative externalities of shale oil production are issues such as land use, waste management and water and air pollution caused by the extraction and processing of oil shale.
The negative impact of mining oil shale deposits is not limited to the usual detrimental environmental consequences of open-pit mining. In addition the combustion and thermal processing generate waste material, which must be disposed of, and harmful atmospheric emissions, including carbon dioxide, a major greenhouse gas. Under some circumstances there is also a risk of the pollution of groundwater.
Demand – the unsung hero
Despite the downward pressure on prices exerted by US shale producers, demand has been the unsung hero of the crude oil market. Demand growth has been robust in the years that followed the global financial crisis and it has gradually picked up in 2017 parallel to stronger global GDP growth.
Demand from emerging economies (‘non-OECD demand’ in oil market jargon) is mainly responsible for the recent strength in demand. We expect imports of crude oil by emerging markets (EM) to continue to support demand growth over the next few quarters. We assume an annual growth rate of around 1.7%. That corresponds to the average year-on-year growth rate in demand since the global financial crisis.
Oil market balance – from surplus to slight deficit
Combining our assumptions for demand growth with our assumption of a very gradual increase in OPEC supply from 2018, and a 5% increase in OECD supply (the same pace as in the 2010-15 shale boom years), we forecast a slight deficit in the global crude market over the next year or so. This follows at least three years of surpluses that coincided with the sharp correction in WTI prices from c. USD 105 per barrel in mid-2014 to below USD 30 per barrel in early 2016 (Exhibit 3).
Exhibit 3: Demand to outpace supply in H2 2017, leading to a deficit in 2017-18
Another indicator that suggests a tightening of conditions in the crude oil market is the crude futures curve. The front end of the Brent futures curve, for example, recently shifted from contango (an upward sloping curve) to backwardation (a downward sloping curve) after close to three years. This means that demand pressure on supply in the physical (spot) market are pushing prices higher at the front end of the Brent futures curve relative to contracts further out the curve (Exhibit 4).
Exhibit 4: Brent futures curve suggests demand is pushing up prices higher at the front end of the curve relative to contracts further away
Conclusion – our price forecasts – we see limited upside
Looking ahead, we still see crude oil prices in a range between USD 40-60 per barrel. This range is only a reference, of course. US shale production should cap the upside as supply responses are likely to be quick and large as prices approach the upper bound. At the same time, as prices approach the lower bound, OPEC is likely to threaten the market with sharper production cuts, which should help put a floor under prices.
Furthermore, because demand is picking up, we would expect prices to drift above the mid-range point of USD 50 per barrel in our baseline scenario. We therefore forecast Brent at USD 55 per barrel (Exhibit 5) and WTI at USD 52 per barrel in 12 months’ time.
Exhibit 5: Brent spot, 12-month futures prices and 12-month forecasts
Written on 06/10/2017