One year ago, the price of oil was hovering around $48 and talk was widespread of the market resetting to a new normal. Shale oil from the United States was flowing, OPEC was struggling to contain its membership with production cuts, and expectations for global economic growth were ambigious.
One year later and OPEC is exhibiting remarkable discipline and while US shale continues to flow unabated, it is in many cases replacing reduced supply internationally. And global growth? Often a leading indicator for future expansion in oil and energy consumption, forecasts have ticked up and expectations are high for the world to incrementally continue to add to its need from crude oil to power economic development.
After the startingly low price levels of the past three years, the market is now fully healed and tightening quickly. The question now on the table is, just how high can crude oil prices go in the current cycle?
chart built by Jason Pfaff in TradingView
Historically, a prime driver of higher oil prices has been friction in the oil producing regions of the world, namely the middle east.
With controversy surrounding the world's relationship with Iran, forecasts now call for markedly lower output from that country. Iranian relations with Saudi Arabia continue to deteriorate.
Recently, there have been a spate of attacks on Saudi oil infrastructure, yet they have yet to materially impact supply. Specifically, Iran-backed Houthi rebels in Yemen have targeted Aramco facilities and an oil tanker. While the market has yet to feel any direct impact due to these events, they do represent an escalation and if the pattern continues, it could pose a threat to future supply levels.
Venezuela is also mired in the middle of a historic collapse of its oil production capabilities. In this specific case, the effects feel priced in. However, a continued downshift in Venezuelean production allows US shale to simply replace that lost production, as opposed to simply adding to the world's net supply of crude.
It is certainly challenging to forecast future global flare ups and their consequences, but as we sit today, it is reasonable to say current global political dynamics are structurally supportive of a continued move higher in crude.
As an extension of that narrative, OPEC has continued to demonstrate remarkable consistency with compliance to production cuts amongst the member nations.
OPEC reported that member nations and their allies achieved 138 percent of pledged output reductions last month, up from 133 percent in January and the highest since the cuts went into effect in January 2017.
OPEC has pledged to keep all cuts in place through at least the end of 2018. Further reinforcing this view, it is widely speculated that Saudi Arabia, arguably OPEC's most powerful member, is determined to see the price of crude oil reach $80 by the time of the IPO of their state oil company, Saudi Aramco. The IPO is rumored to happen in late 2018.
Backwardation in the Oil Futures Curve
For commodity traders, a strong indicator of future pricing trends is the longer term forward futures curve.
That curve is currently in backwardation. This is a phenomenon where the future price of oil is lower than the spot price, and a signal of a tightening market. This impacts the market in several ways. First, there is less incentive for a producer to store oil given the higher price point available on the market. Second, there is incentive for traders to take long positions in oil to try and captue "roll yield". By rolling shorter term contracts into longer term contracts, an oil investor could take profits on long positions in oil, even when the spot price does not move. The expectation being that the future month price will rise to meet the current spot price as we move forward in time. The net effect for a short term trader is there could be an expectation of additional long positions being opened which is constructive to pricing dynamics short term.
Outlook for WTI Crude Oil Price
Taking a long view, our current base case is for the completion of a classic v-shaped recovery in oil price as we move through the next twelve months.
Based on the analysis of a predictive neural network model used to forecast future tracks for pricing, we could see a sustained move to above 75$ over the next four months. Over the next six months $80 dollars is certainly in striking distance.
For the balance of the year, a level of $90 is certainly in play, and we could see that by next spring according to the mathematical analysis.
mathematical model and visual built by Jason Pfaff, historical data via St. Louis Federal Reserve
Risks to that outlook would be cooling economic growth combined with continued record output from US shale producers and a recovery in global output from key oil producing regions. Most impactful would be an end to the OPEC prodcution cuts, and while that is unlikely in our view, if that were to happen it could cause a significant depression in pricing in a very rapid fashion.