Is $45 To $55 Per Barrel The Goldilocks Range For Crude Oil Prices?

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The last few days have been quite eventful for the commodity markets, particularly crude oil, as the anticipation of a production quota by the Organization of Petroleum Exporting Countries (OPEC) caused oil prices to move rapidly in the last week. The world’s largest cartel finally reached an understanding to cap their combined oil production between 32.5 and 33 million barrels per day, marking its first coordinated production quota in the last eight years. The news prompted the global benchmark of crude oil prices – WTI and Brent – to jump by 5%-6% in a single trading day. However, as the market absorbed the announcement, some of the industry experts have been doubtful about the improvement in the oil prices that the investors are expecting from the production cap. Here are some of the factors that are leading to the skepticism in investors:

  • Iran And Others May Not Commit To The Deal – Firstly, since the OPEC has not reached a formal agreement regarding the output restriction, it is still ambiguous as to what the individual production limit for each of the member countries would be. This is particularly disturbing as there is a notable portion of the market that believes that Iran would not favor an output quota, and would not enter an agreement until it achieves its pre-sanction production levels. Furthermore, it would also be difficult to bring member countries like Iraq, Libya, and Nigeria on board to restrict their output, since they intend to expand production to augment their deteriorating economies.
  • Poor Track Record Of Adhering To Output Quotas – Secondly, the OPEC does not have a strong track record of adhering to the output ceiling agreed and formulated by its own member countries. The Non-OPEC countries have accused the OPEC countries of breaching output treaties at several instances in the past. Thus, there is a strong perception that even if the agreement is formalized in the OPEC’s next policy meeting, there would be no measure or guarantee to ensure that the member countries would abide by the terms of such an agreement.
  • Is The Production Cap Enough? – The market is divided upon the amount of production cut that is being proposed in the deal. According to the initial details released from the Algeria meeting last week, the OPEC is expected to restrict its combined oil production between 32.5 and 33 million barrels per day. On comparing this with the cartel’s August output, this would imply a reduction of  about 200 to 700 MBPD (thousand barrels per day) of output in the coming months. While this cut could create a dent on the existing supply glut in the oil markets considering the declining US production, it may still not be enough to revert oil prices back to even $60 per barrel in the near future.

Having analyzed the market reaction to the OPEC’s move, we move ahead to discuss our views on why we believe that crude oil prices will not move beyond $45-$55 per barrel range in the next couple of quarters. (Also read: Is It Time For Crude Oil Prices To Recover?)

To begin with, we present below a chart depicting the crude oil prices, both WTI and Brent, over the last five months. Ever since the supply disruptions in Canada (wildfire), and Venezuela and Nigeria (financial instability) hit the oil markets in the second quarter of 2016, the oil prices have been on the rise. The oil prices rose from an all-time low of under $30 per barrel in February to around $50 per barrel in May. While the recovery did not last long, crude prices have oscillated between $40 and $50 per barrel over the last five months. However, the prices have not stayed at above $50 per barrel for long during this time.

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Oil-Q&A-goldilock-1

Source: US Energy Information Agency (EIA)

At first this might seem like a coincidence. However, on digging further one can apply a financial logic to the situation. As is commonly known, most of the OPEC countries have a low cost of production for oil compared to the US tight oil producers. To bring some perspective, the majority of the Middle East countries incur a cost of $20-$30 to produce an additional barrel of oil, whereas a typical tight oil producing company in the US would produce the same oil for about $40-$60. Since the primary objective of OPEC countries was to push the US shale producers out of the markets and preserve their market share, the members of the cartel ensured that the oil prices did not move beyond $50 per barrel, which would make it financially viable for the US oil producers to pump more oil.

Oil-Q&A-goldilock-2

Source : EOG Resources Investor Presentation

However, of late the OPEC countries have been caught in their own game, as the depressed oil prices have severely hit their oil dependent economies. Consequently, the members of the cartel finally blinked and decided to restrict their output last week.

Impact Of The OPEC’s Move

In terms of the impact of the OPEC’s move, as suggested by the market experts, we too expect a $5-$7 per barrel improvement in oil prices once the agreement is finalized among the OPEC members. Given this uptick in price, we believe oil prices to oscillate in the $45-$55 per barrel over the next few months. This is based on the assumption that once the oil prices stabilize at a point between $50-$55 per barrel, it would prompt US tight oil producers to reinstate their output, since it would become economically viable for them to do so. This would increase the supply of oil in the global markets, causing the oil glut to grow again. This would dilute the impact of OPEC’s move to cut output, and lead to a drop in oil prices.

Thus, the oil markets are trapped in a vicious circle, where the OPEC and US tight oil producers will continue to maneuver their output to push the other one out of the market. It remains to be see who will win this battle. However, for now, the key take away from the news is that the oil prices are likely to improve, at least in the short term, which will work in the favor of oil and gas giants such as BP Plc.

See Our Complete Analysis For BP Here

 

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