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Why Oil Prices Are Headed Higher In 2018

Oil prices are driven by cycles of fear and complacency. During the cycle of fear, geopolitical events can quickly send the price of oil soaring. During the cycle of complacency, oil prices often seem immune to bullish news.

Over the past decade, the world has experienced both cycles.

The Cycle of Fear

A decade ago “peak oil” was helping drive the fear cycle. Many credible voices asserted that oil production was nearing terminal decline. For a while, it looked like they might be right.

Production in Saudi Arabia remained flat even as global demand continued to grow, and oil prices skyrocketed above $100 a barrel (bbl). These were just the types of consequences predicted by those who were forecasting an imminent terminal decline.

But the reality was that Saudi Arabia and OPEC were happy with $100/bbl oil, and they were slow to increase production, arguing that the world was well-supplied. Fear mostly had the upper hand from about 2005 until mid-2014.

Shale Oil Saves The Day

U.S. oil production had fallen for nearly 40 years. But then, the marriage between hydraulic fracturing and horizontal drilling ushered in the shale oil boom. Oil production began to rise in 2009, and then grew at the fastest rate in history.

 

Complacency Returns

All that new U.S. production began to push oil supply ahead of demand. OPEC responded with a war for market share, and it added nearly three million BPD into a well-supplied market.

The result was a surge of global inventories and the collapse of oil prices. Complacency returned, and has ruled the markets since mid-2014.

But the oil markets are moved by inventories. In November 2016 OPEC announced a plan to reverse the inventory build they helped create. OPEC announced that it would enact 1.2 million BPD of production cuts. Certain major non-OPEC members – most notably Russia – would cooperate with the production cuts, pushing the total amount of targeted cuts to 1.8 million BPD.

Through the spring and summer, crude oil demand continued to grow, crude oil inventories declined, but the price of oil failed to move.

Finally, in late August of this year, it started to become apparent that oil supplies were falling behind demand. The price of WTI moved up from the mid-$40s to the upper-$50s, and Brent crude rose to over $60/bbl — the highest level in two years.

Fear is creeping back into the oil market, as evidenced by the recent spikes from political unrest in Saudi Arabia. 

Higher Oil Prices in 2018

Global demand for oil continues to grow unabated. Despite government mandates in support of biofuels, higher fuel economy standards, and the explosive growth of electric vehicles (EVs), global demand has grown at an average rate of 1.1 million barrels per day (BPD) for more than 30 years:

The International Energy Agency expects oil demand to grow by 1.6 million BPD this year and by 1.4 million BPD in 2018.

The likely scenario for 2018 is a continuation of the tightening that has been underway for the past six months. As the market continues to tighten, prices will continue to rise, but the fear cycle will gradually become more prominent. This once again increases the risk of oil price spikes based on geopolitical events in oil-producing regions.

The only real threats to this scenario are OPEC having the ability to – and deciding to – once again flood the market. This is unlikely given the steep price they paid for taking this action in 2014. Alternatively, a global recession is the only other likely candidate for curbing oil prices. Otherwise, $70/bbl or more looks likely in 2018.


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