The Macro Report | March 2017

Oil in a time of shale


The days of $100 oil are not likely to come again soon. Given what we know about supply and demand, we view the $40–$50 range for a barrel of Brent crude to represent fair value.

When OPEC announced output cuts in late 2016 as part of an effort to reduce record stockpiles and push oil prices into a higher range, we were initially skeptical about the credibility of the cuts. But the market seemed happy to hear about the agreement, and Brent rose to hover around $55 through January and February. Some market participants might take this temporary price change to indicate OPEC’s good-faith participation in the effort to reduce global supply.

However, in early March, oil prices suddenly tumbled, and there are many possible explanations for that decline. One is doubts about OPEC compliance. OPEC made about 1.5 million of its promised 1.8 million barrel-per-day cut in January, but informed observers think OPEC’s compliance with the agreement slipped in February. While we cannot rule out another round of OPEC-led talks and resolutions to cut production, we think OPEC has lost some of its ability to control oil prices. When it comes to promised oil production cuts, the incentives to comply are few, while the incentives to cheat are many.

Shale may dull the edge of energy inflation

Another factor driving the price of oil — one that we think may ultimately represent a much stronger factor going forward — is U.S. shale output. Shale output has risen much faster so far in the first quarter of 2017 than was widely expected just three months ago, and it is on track to make significant gains the rest of this year.

U.S. shale oil production costs have continued to fall, and the Trump administration’s relaxation of permitting and environmental rules for domestic production will push extraction costs down even further.

The reason for this is that U.S. shale oil production costs have continued to fall, and the Trump administration’s relaxation of permitting and environmental rules for domestic production will push extraction costs down even further. Generally speaking, commodity prices have to fall to the level that regulates the output of the marginal producer; in global oil markets, the marginal producer is currently U.S. shale. For this reason, we think there is some modest downside risk to oil prices, unless global demand starts to grow significantly in the near term. This is not something we expect to see.

At the margin, $5 off the current (~$50) price of oil is supportive of global growth. And at this lower level, it could produce a one-off drop in prices that affects measured inflation. At a time when much of the global reflation story is pinned to commodity prices, a drop in oil could thus have an important impact on how inflation affects financial markets. To be clear, a lower oil price would not threaten a return of deflation worries, but it would take the edge off fears of inflation moving significantly higher.


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