June 18, 2018
John LaForge, Head of Real Asset Strategy
Oil—How Low Can It Go?
- At $67 per barrel, WTI (West Texas Intermediate) oil prices look high to us. Global supply growth continues to outpace demand growth.
- In addition, Saudi Arabia has floated the idea of increasing oil production.
What it May Mean for Investors
- We are expecting WTI crude-oil prices to head into the $50s by the end of 2018.
“Not every mistake is a foolish one.” – Cicero
Gasoline prices have been the hot topic in 2018. And rightfully so. Gas at the pump now averages $2.91 per gallon—about 20% higher than it was at this time last year.1 A few weeks ago, the average price came close to the psychological threshold of $3.00 per gallon level, which is one reason why we are fielding so many gas and oil questions today.
Fortunately for summer drivers, average U.S. gas prices did not climb above $3.00 per gallon. This is because oil prices hit a wall at around $73 per barrel, and have since slipped back to $67. This can be seen in Chart 1, which shows the price of WTI crude oil. The shaded area represents our target price range for the next 12 months. The midpoint of our range is $55. The fact that our 12-month target of $55 per barrel is lower than today’s $67 WTI oil price is obvious. In today’s report, we will discuss why we’re expecting lower oil prices over the next year.
In complete candor, we never expected the price of WTI oil to hold much above $60 in 2018. We have been wrong—as WTI finished 2017 at $60 and has closed above $60 nearly every day since. So, for the first half of 2018, we say, “mea culpa.”
Markets can be quite humbling, and stories can change, so we always remain open to adjusting our stance. In the case of oil, we are not changing our bearish stance. The case for lower oil prices continues to build. As for why we’re sticking to sub-$60 WTI oil prices, the primary driver is too much supply. Chart 2 highlights the world’s top petroleum-producing (oil-producing) countries. Notice U.S. oil production (shown in the blue line), which is hitting record highs. This is due to a combination of high prices, and the rise of shale oil production. Further, an end to record production levels does not seem to be in sight. To stop this ascent and force U.S. producers to slow down, we’ll likely need to see lower oil prices.
With such a swelling in U.S. oil supplies, a rational person could think that prices should have faded by now. We certainly did. But that has yet to happen—as some other major oil-producing countries have conspired to restrict their own production—namely Russia, Saudi Arabia, and the rest of the Organization of Petroleum Exporting Countries (OPEC). This also can be seen in Chart 2. Russia is shown in the green line; Saudi Arabia is tracked by the purple line.
As 2018 has progressed, we have wondered how long Russia and OPEC could continue to restrict their production. After all, rising global prices create their own sort of internal pressures to capitalize upon higher prices. In the case of Saudi Arabia, as an example, oil revenues are used to fund social programs, government bonuses, etc. Russia, as another example, needs the U.S. dollar inflow (oil is largely traded in U.S. dollars), to do its business outside of Russia.
The other big negative here for Russia and OPEC is that the longer they restrict production, the more they are losing market share to the U.S. Chart 3 highlights this dynamic. The blue bars represent total world production, around 98 million barrels per day. The green line is U.S. market share, which stands at 18%. This may not sound like much, but a decade ago, the U.S. produced only 10% of the world’s oil. On the other hand, OPEC’s market share (Chart 3, red line) has slipped in the past decade from 43% to 39%, and it continues to slide.
The time for Russia and OPEC to release production restrictions may be near. We say this because Saudi Arabia floated the idea at the end of May. This is a 180-degree turn in rhetoric from OPEC communication in 2016 and 2017. And the market reacted, as we suspected that it would. WTI oil prices dropped nearly 10%, after the Saudi announcement.
Overall, the balance between supply and demand continues to tip on the side of too much supply. Chart 4 shows the balance between growth in global supply and demand. A falling green line means that global supply is growing at a faster rate than demand is. When this has happened historically, oil prices have eventually given in and faded, too. (Oil prices are represented by the blue line in Chart 4.)
Lastly, we’ll end with $67 oil prices, from the perspective of my 16-year-old daughter. We repeatedly hear that oil prices should be higher, if only because $67 is too low historically (adjusted for inflation). Our answer, in 16 year-old speak is “ah, no—that is literally not true.” Chart 5 shows oil prices, adjusted for inflation, back to the first time that oil was found and produced in the U.S., around 1860. Today’s $67 price is about twice the historical average of $35. So, no, prices today are not low. In fact, they are quite high, historically speaking.
The bottom line is that $67 WTI prices look high to us. We are expecting WTI oil to head into the $50s by the end of 2018.