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The rally in oil prices over the past year likely had more to do with higher demand rather than merely the supply taken off of the market by the OPEC/non-OPEC cuts. That suggests that as OPEC tries to formulate a strategy going forward, perhaps targeting a certain price level, much of the success of that campaign will depend on the global economy and the pace of oil demand growth.
That conclusion comes from a new report published by the Oxford Institute for Energy Studies (OIES). The report parses out some of the variables determining prices in recent years, dividing the recent past into four main cycles: 1) OPEC defending market share (2013-2015); 2) OPEC’s high output/low-price strategy to drive out shale (2015-2016); 3) OPEC/non-OPEC cuts (June 2016-April 2017); and 4) OPEC’s strategy to drain stocks (May 2017-present).
Throughout these four stages, one interesting conclusion is that the demand story is incredibly important, arguably more important than the market realizes, in driving the price of crude. The last half-decade, the focus in the media and among analysts is usually on the supply picture (U.S. shale growth, for instance, or the OPEC cuts), but evidence suggests a slowdown in demand or unexpected strength tends to have just as much influence, sometimes more.
Let’s rewind to phase one. Between 2013 and 2015, the cartel was producing flat out in an effort to defend market share and drive U.S. shale producers out of business. The high levels of supply were definitely a key driver in the crash in oil prices. But the demand story was also important. Between late 2013 and early 2015, OIES estimates that Brent crude lost roughly $38 per barrel due to the combined tidal wave of U.S. shale and higher OPEC production. Still, it wasn’t just a supply story. The slowdown in the global economy also led to the loss of $26 per barrel.
When U.S. shale started to crash in 2015 and the early part of 2016 (phase two), the supply losses from the U.S. added the equivalent of $12 per barrel back to Brent. But again, the poor economic performance and weaker demand – despite lower oil prices – took off a whopping $20 per barrel from Brent (there are other factors moving prices up or down, but supply shocks and demand growth are paramount).
To be sure, OPEC and its non-OPEC partners agreed to remove upwards of 1.8 million barrels per day of supply off of the market in late 2016 (phase 3), but initially, at least, the fundamentals did not reflect this fact. Member countries ramped up output just ahead of the start of the deal at the end of 2016, flooding the market just ahead of the cuts. The price increases, then, were the result of speculation in anticipation of the cuts. Brent posted losses when the speculative euphoria wore off. Higher U.S. shale and poor OPEC compliance resulted in a loss of $5 per barrel over this period, which is notable because strong demand had the effect of adding $6 per barrel over the same timeframe. Again, a demand story.
Finally, in phase four (mid-2017 to present), the supply picture has been muddled because much higher OPEC compliance has been occurring at a time when U.S. shale was ramping up. OIES estimates that shale growth probably depressed prices by $4 per barrel in 2017, while higher OPEC compliance added $1 per barrel in the second half of the year. In the first half of the year, the OPEC cuts had very little effect because of poor compliance and front-loaded growth.
OPEC and shale somewhat offset each other in 2017. But the crucial message from the OIES report finds that in 2017, soaring global demand, coming on the back of a strong economic expansion (3.7 percent GDP growth), adding roughly $12 per barrel to the price of Brent crude.
OIES says the “success” of OPEC’s strategy “has been largely demand-driven, as was the ‘failure’ of its previous high-output strategy during the 2015-2016 cycle.”
In other words, OPEC’s effort to flood the market in 2015 and 2016 helped knock back U.S. shale, but it occurred at a time when the global economy sputtered, and the “bad timing” led to a crash in prices. Meanwhile, while OPEC took barrels off of the market last year, significant price gains had more to do with the strong economy.
This isn’t just a bit of interesting history – it offers lessons going forward for OPEC as it considers its options. “A key factor that should be shaping the current OPEC oil policy is the expected strength of global demand growth,” OIES wrote. “Oil prices in 2018 more sensitive to the downside to a downward revision of global demand growth rather than an equivalent upward revision of US shale supply growth.”
OIES estimates an unexpectedly weak economy, for instance, could drag oil down by $5 per barrel while an unexpectedly strong increase in shale supply would only push prices down by $2.50.
Practically speaking, then, the prospect of a trade war should loom larger than one might think for OPEC because it could endanger GDP growth. To compensate for a weak economy, OPEC would need to cut an additional 1 mb/d, according to OIES, while to compensate for surging shale, OPEC would only need to cut 0.5 mb/d to have the same price effect.
Obviously, for OPEC, strong demand is desirable. It would allow the group to keep the cuts in place for as long as it wants and then phase them out. However, OIES says that if global demand surprises to the downside, “OPEC choices become very stark: OPEC could either decide to cut output or shift towards a higher output strategy. Both choices carry hefty risks reflecting delicate situation that OPEC finds itself in.”
By Nick Cunningham of Oilprice.com