Outlook for crude oil: Implementation of OPEC deal holds the key

Kishore Narne | Updated on January 16, 2018 Published on December 23, 2016

Crude oil witnessed a roller-coaster ride in 2016 with prices threatening to dip below $40/barrel at one point but are now aiming towards $60. While lower prices provided a boost to consumers and lowered inflation in emerging economies, it impacted the economies of oil producers.

The narrative is set to change in 2017 as consumers will have to cope with higher prices as producers co-operated and implemented a supply cut. Higher oil prices will also underpin inflationary pressures after having dented them over the past two years. This will, thereby, impact interest rates, global bond yields and eventually the entire global market.

Against this backdrop, it is important to see if the oil rally is sustainable and how long will it take for shale producers to come back into the fray and spoil the party for OPEC.

The OPEC deal helped sentiment in oil markets especially since we saw a sense of unison among members after a long time. Oil prices have jumped more than 15 per cent since the deal and the co-operation by non-OPEC members offered a further boost to prices. The deal between producers means that 1.8 million bpd of supply will effectively go off the market starting January and bring the oil market in balance and possibly a deficit by the middle of 2017. This has led to record speculative positions being built in both WTI and Brent in recent weeks.

Shale production factor

The biggest limitation of the deal is that it will end up providing a lifeline to the same high cost producers the OPEC intended to push out of business in 2014.

Data show that US oil rig count has been increasing since June after a nearly 80 per cent decline before that. The numbers of active oil rigs have now increased for nearly four consecutive months.

US shale output is expected to increase in January for the first time in five months suggesting that shale is starting to make a slow comeback. January production will edge up 1,200 barrels per day to 4.542 million bpd. In the most prolific Permian Basin of West Texas, output is projected to rise by 37,000 bpd to 2.13 million bpd.

A ball-park estimate suggests that productivity improvements have reduced marginal production costs by approximately 40 per cent which means that most of the big shale oil producers will remain viable if prices stay above $45. In this context, if oil prices stay around $55-60, producers will have greater incentive to pump more oil which effectively makes the US the new swing producer in the market.

Prices may rise

Nonetheless, based on current circumstances, oil prices are likely to inch higher in 2017 and feed into the inflation dynamic as well. Inflation readings globally will start to see further upticks in y-o-y comparisons given that oil prices have been subdued since 2014.

Already, global markets are pricing in a reflation trade and this will end up impacting monetary policy decisions and consequently currency markets as well. In that context, the pace at which oil prices move higher will be important.

If the OPEC is successfully able to implement its deal, the trajectory of prices will be steeper as the demand-supply dynamic will shift towards deficit by the middle of 2017. If the OPEC fails to deliver, the price recovery will be slow and prolonged until the end of next year.

The writer is Head - Commodity & Currency, Motilal Oswal Commodities Ltd. Views are personal.

Published on December 23, 2016
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