The global supply and demand balance of oil is improving, while OPEC mulls boosting output in the second half of 2018.

Oil prices rose quite sharply from the middle of April until the last few days of May. Prices are currently a little higher compared with where they were a month ago. Global oil prices will be driven by supply factors because the demand side of the equation appears to be quite steady.

In the United States, where it’s a bit easier to analyze demand trends, there’s no sign that higher gasoline prices have hampered driving habits. It’s possible that demand from China looks a bit stronger than it really is because there may be some large purchases from China for inventories. But we doubt this can explain much of the recent spike in prices.

On the supply side, however, there were a host of factors that influenced prices. There is mounting difficulties with output from Venezuela. There is also the risk that the United States will step up sanctions on the country, further limiting supply. Then, there is the likelihood that exports from Iran will decline, following the withdrawal of the United States from the multinational nuclear agreement. Still, it’s not clear how much exports from Iran will drop. We also have periodic outage problems in Nigeria and worries about output from Iraq. In addition, U.S. shale output is rising in reaction to the run-up in prices.

There are debates in the market about the effects of sanctions on Iranian oil production and about the extent of decline in Venezuela’s output. These exact numbers do matter. The output discipline of the Organization of Petroleum Exporting Countries (OPEC) and non-OPEC producers led by Russia have been very strong in recent months. In late May, however, Saudi Arabia and Russia signaled a change and indicated their willingness to boost oil output in the second half of the year.

All options are on the table

There were many reasons for this policy swerve. President Donald Trump has publicly complained on Twitter about OPEC policy and rising oil prices. And Saudi Arabia, the world’s largest oil exporter, intends to cement its close relationship with Trump and his anti-Iranian policies. OPEC also has no interest in pushing prices up to levels that will threaten demand or encourage even faster growth in shale output from the United States. News reports that OPEC could lift oil output pushed prices lower in late May.

The Saudis and the Russians are apparently still arguing about how much to raise oil output in the second half of the year. And since the production shortfall from Venezuela and Iran remains unknown, we can’t forecast with confidence the supply outcome. Right now, we think prices are in line with our fair value estimates. Whether that estimate edges up or down will be influenced by the size of the output increase that OPEC agrees. It’s worth noting that our fair value estimate was driven by an appreciating U.S. dollar, and not by a shift in underlying market dynamics.

Finding a fair value

There are two important points in determining oil’s fair value. First, the probability of much higher oil prices has fallen. Market watchers eyeing $90 or $100 per barrel for Brent crude were always too bullish. Now, however, we have a clear signal from OPEC that there is a ceiling on prices. Secondly, prices were close to fair value at the end of May. Our fair value model isn’t a forecasting tool. We can’t claim that prices could be $5 lower or higher, and not be consistent with our fair value.

Right now, we think prices are in line with our estimate of fair value.

Today’s prices are broadly consistent with the balance of supply and demand. It will take a major shift in these supply and demand dynamics to push prices to a significantly different level.

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