Crude Prices Surge as the Pieces Fall Into Place

I have been pretty adamant — some may say stubbornly so — about my expectations for crude prices this year. I have argued against the notion that oil prices were going to fall to $20 or $30/bbl for several reasons. In a nutshell, those reasons are:

  • This is well below the marginal cost of shale oil production, and you can expect shale oil supplies to begin contracting in response to falling prices
  • Growing crude oil inventories will peak soon for seasonal reasons
  • Lower oil prices will spur demand

I have made this argument a number of places, including in a recent Wall Street Journal article. Noted oil analyst Philip Verleger made a comment following that article that those calling for collapsing prices are correct, and he patted himself on the back with the comment “A few of us who make a living in the field did (call the price collapse correct)” while arguing that those writing for the Wall Street Journal don’t “seem to understand what is going on” and are “in the dark ages.” Them’s fighting words!

I think Verleger’s comments — albeit more arrogant and condescending — are pretty typical of the way most analysts make predictions. First, his prediction of a collapse was made in the Fall when the collapse was well underway. Oil had already fallen sharply when Verleger wrote an article in which he said “further declines seem likely.” This seems to be the way it goes with many oil analysts. Whatever the direction oil prices are taking, the safe bet seems to be to predict another $10-$20/bbl movement in that direction. In contrast, I would note that I predicted lower oil prices well before they started to fall last summer. While there is certainly a lot of year left, I would also note that oil prices have risen by 10% since Verleger defended those predicting collapse.

In response to Verleger, I would argue that I do have a pretty good understanding of what’s going on, and I have argued that oil prices had to move higher on the basis of sound fundamental analysis. Today we have evidence of all 3 factors I mentioned above, and not coincidentally the price of West Texas Intermediate (WTI) has now¬†surged to its 2015 high point, above $56/bbl.

Today the Energy Information Administration (EIA) released its weekly Weekly Petroleum Status Report. Crude oil inventories, which had been growing by 7 to 10 million barrels per week this year, only grew by 1.3 million barrels last week. The reasons were that refinery inputs picked up by 283,000 barrels per day (bpd), crude oil imports fell by 1.1 million bpd from last week, and U.S. crude oil production declined by 20,000 bpd — the second decline in the past 3 weeks.

Meanwhile, today the International Energy Agency also increased their demand growth projections for crude oil this year to a gain of 1.1 million bpd over 2014 (which gained 700,000 bpd over 2013). Low prices have a funny way of spurring demand.

Finally, Iranian Oil Minister Bijan Zanganeh came out this week with a call for OPEC to cut its production output by 5%, a move favored by most OPEC members (but a move that has been opposed by its strongest member, Saudi Arabia).

It shouldn’t be a surprise that on the back of all of this news, crude futures jumped 6% today.

Before we get too far ahead of ourselves, I don’t think we are going to return to $100/bbl any time soon. I think it’s likely that we go back above $60/bbl, but then you will start to see some supply side response as the rig count picks back up. There is going to be some resistance to the upside as we have to wait for demand growth to catch up to idled capacity, and there will be resistance below $50/bbl because of the marginal production that simply isn’t economical to produce at that price.

Thus, I think we will likely trade in a range of $50/bbl to $70/bbl for a period of time, unless OPEC does cut production quotas at their next meeting in June.

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