Oil Prices To Remain Steady

Crude oil prices will average $51/barrel in 2017 and $52/b in 2018. The U.S. Energy Information Administration makes these predictions monthly. It reports that volatility won’t be as bad as in 2016.

Commodities traders also predict the price of oil in their futures contracts. They predict the price could be anywhere from $37/b to $68/b by December 2017. Prices have inched up since last month’s prediction.

 (Source: “Short-Term Energy Outlook,” EIA, August 8, 2017.)

In July, oil prices rose to $48/b. That’s $2 a barrel higher than in June. It’s double the 13-year low of $26.55/b on January 20, 2016. Six months before that, oil had been $60/b (June 2015). A year earlier, it had been $100.26/b (June 2014). Here’s Today’s Oil Price. (Source: “WTI Oil Settles at Nearly a 13-Year Low,” Marketwatch, January 20, 2016.)

The price of a barrel of West Texas Intermediate oil is $2/b lower than Brent North Sea oil prices. WTI used to be $4/b less than Brent. It rose when Congress removed the 40-year ban on exports in December 2015.

The EIA forecasts couldn’t keep up with the unpredictability of oil supplyversus demand in 2015 and 2016. That’s because the oil industry changed in fundamental ways.

What’s Caused These Wild Swings in Oil Prices?

Oil prices used to have a predictable seasonal swing. They spiked in the spring, as oil traders anticipated high demand for summer vacation driving.

Once demand has peaked, prices dropped in the fall and winter.

So why have oil prices been so volatile? Here are three reasons.

First, U.S. production of shale oil and alternative fuels increased. Total U.S. production rose to 9.4 million barrels per day in 2015, the highest since 9.6 million b/d in 1970.

 Such high production was surprising because oil prices were falling.The number of oil rigs had declined by 60 percent nationwide, too.

Why was the U.S. producing so much oil at such low prices? Shale oil producers had become more efficient in extracting oil. They found ways to keep wells open. They didn’t want to incur the expense of capping off their wells. For them, it made more sense to keep pumping oil despite falling prices.

Less-efficient shale producers had to either to either cut back or go out of business. That reduced supply by around 10 percent. For more, see U.S. Shale Oil Boom and Bust.

At the same time, massive oil wells in the Gulf came on line. They couldn’t stop production regardless of low oil prices. (Source: “As Oil Prices Fall, No One Is Blinking,” The Wall Street Journal, December 7, 2015.)

As a result, large traditional oil enterprises stopped exploring new reserves. These companies include Exxon-Mobil, BP, Chevron and Royal Dutch Shell. It was cheaper for them to buy out smaller shale oil companies. (Source: “Oil Slump Sets Scene for Mergers,” The Wall Street Journal, January 29, 2016.)

U.S. oil production fell to 8.9 million b/d in 2016. It’s expected to rise to 9.3 million b/d in 2017 and 9.9 million b/d in 2018.

That would be  the highest annual average production in U.S. history. It would beat the previous record of 9.6 million b/d set in 1970. (Source: “Short-Term Energy Outlook,” EIA, August 11, 2017.)

The second reason for recent volatility is foreign exchange traders. They drove up the value of the dollar by 25 percent in 2014 and 2015. All oil transactions are paid in dollars. The strong dollar helped cause some of the 70 percent declines in the price of petroleum for exporting countries. Most oil-exporting countries peg their currencies to the dollar. Therefore, a 25 percent rise in the dollar offsets a 25 percent drop in oil prices. For more, see Why Makes the U.S. Dollar So Strong?

Since December  2016, the dollar’s value has been falling. On December 11, 2016, the USDX was 102.95. In early 2017, hedge funds began shorting the dollar as Europe’s economy improved.

As the euro rose, the dollar fell. By July 27, 2017, it reached 93.94.  (Source: “DXY Interactive Chart,” Marketwatch.)

Third, OPEC didn’t reduce output to put a floor under prices until November 30, 2016. Its members agreed to cut production by 1.2 million barrels by January 2017. That lowered production to 32.5 million b/d. But the so-called cut was higher than its 2015 average of 32.32 million b/d. Prices began rising right after the OPEC announcement. (Source: “OPEC Confounds Skeptics, Agrees to First Oil Cuts in Eight Years,” Bloomberg, November 30, 2016.)

On May 25, 2017, OPEC extended these cuts through March 2018.  The EIA forecasts OPEC will produce 32.3 million barrels b/d in 2017 and 32.8 million b/d in 2018. But  both figures are still higher than the 2015 average before the “cuts.”

Throughout its history, OPEC controlled production to maintain a $70 price target. In 2014, it abandoned this policy. Saudi Arabia, OPEC’s biggest contributor, lowered its price to its largest customers in October 2014. It did not want to lose market share to U.S. shale producers or its archrival, Iran. Iran promised to double its oil exports to 2.4 million b/d once sanctions were lifted. The nuclear peace treaty allowed Saudi Arabia’s biggest rival to sell oil in 2016. For more, see Sunni/Shiite Conflict.

Saudi Arabia correctly bet that lower prices would force many U.S. shale producers out of business, reducing its competition. At first, shale producers found ways to keep the oil pumping. Thanks to increased U.S. supply, demand for OPEC oil fell from 30 million b/d in 2014 to 29 million b/d in 2015. But the strong dollar meant OPEC countries could remain profitable at lower oil prices. Rather than lose market share, OPEC kept its production target at 30 million b/d.

At the same time, global demand grew slowly, from 92.4 million b/d​ in 2014 to 93.3 million b/d​ in 2015, according to the International Energy Administration. Most of the increase was from China, which now consumes 12 percent of global oil production. But its economic reforms are slowing growth.

In February 2016, Saudi Arabia, Russia, and Iran discussed a production freeze. That briefly put a floor under plummeting oil prices. But it didn’t pan out because Iran and Russia refused to cut their production. (Source: “Oil Up 7 Percent as Iran Welcomes Output Freeze,” Reuters, February 17, 2016.)

Oil Price Forecast 2020 and 2040

By 2020, the average price of a barrel of Brent crude oil will rise to $79/b (in 2015 dollars, which removes the effect of inflation). Shale oil production will slow after 2021. This will contribute to a decline in total U.S. oil production through 2040.

By 2040, world demand will start driving oil prices to $136.21/b (again in 2015 dollars). By then, the cheap sources of oil will have been exhausted, making it more expensive to extract oil. (Source: “Annual Energy Outlook,” September 15, 2016.)

The forecasts all depend on 1) what happens with U.S. shale oil production, 2) how OPEC responds, and 3) how fast the global economy grows. These are all so uncertain that the EIA is unwilling (or perhaps unable) to set a hard forecast.

Could Oil Prices Rise Above $200 a Barrel?

Oil prices reached the record high of $145/b in 2008 and were $100/b in 2014. That’s when the Organization for Economic Cooperation and Development forecast that the price of Brent oil could go as high as $270/b by 2020. It based its prediction on skyrocketing demand from China and other emerging markets. It seems unlikely now that shale oil has become available.

The idea of oil at $200/b seems catastrophic to the American way of life. But people in the European Union were paying the equivalent of about $250/b for years due to high taxes. That didn’t stop the EU from being the world’s third-largest oil consumer. As long as people have time to adjust, they will find ways to live with higher oil prices.

Furthermore, 2020 is only three years away. Look how volatile prices have been in the last 10 years. In March 2006, a barrel of Brent Crude sold for around $60/b. It skyrocketed to $145/b in 2008. It leveled out to around $100/b in 2014. It plummeted to a 13-year low in January, then doubled to current levels. If shale oil producers go out of business, and Iran doesn’t produce what it says it could, prices could return to their historical levels of $70 – $100 a barrel. OPEC is counting on it.

The OECD admits that high oil prices slow economic growth and lower demand for oil itself. High oil prices can result in “demand destruction.” If high prices last long enough, people change their buying habits. Demand destruction occurred after the 1979 oil shock. Oil prices steadily deteriorated for about six years. They finally collapsed when demand declined and supply caught up. (Source: Jenny Gross, “OECD Says Oil Prices Could Reach $150-$270 BBL by 2020,” The Wall Street Journal, March 6, 2013.)

Oil speculators could spike the price higher if they panic about future supply shortages. That’s what happened in 2008. Traders were afraid that China’s demand for oil would overtake supply. Investors drove oil prices to a record $145/b. These fears were grossly unfounded, as the world soon plunged into recession and demand for oil dropped. For more, see Gas Prices in 2008.

Keep in mind that any perceived shortages can cause traders to panic and prices to spike. Perceived shortages could be caused by hurricanes, the threat of war in oil-exporting areas or refinery shutdowns. But prices tend to moderate in the long term. Here are the Three Factors That Determine Oil Prices.