Weakness in oil prices forced OPEC and its allies to try to stabilize the market with production cuts as the United States reimposed economic sanctions on Iran.

In early December, OPEC and its allies reached an agreement to slash oil production amid the sharp drop in prices. Members of OPEC and Russia, an oil producer outside the cartel, also engaged in some elaborate diplomacy about output levels for 2019. The deal, which should help eliminate excess supply, has prompted oil prices to edge up slightly. Crude futures have tumbled by more than a third since climbing to four-year highs in early October 2018. Rising concerns about oversupply, higher inventories, and the risk of a global economic slowdown have all placed downward pressure on the value of a barrel of oil.

Oil is currently trading at several dollars above its recent lows. However, our fair value for oil has dropped by a few dollars, partly because the U.S. dollar has risen, partly because inventories are a bit higher than we expected, and partly because our annual recalibration of the parameters model for prices. But the fair value estimate is very much higher than current prices. We also note that the futures market positioning for crude oil has shifted dramatically in the past few weeks.

Market prices are well below our fair value estimate

Back in the spring of this year when prices were higher than today and rising, inventories were dropping. There was concern that, with the threat of U.S. sanctions looming, Iranian exports would drop sharply. The fantasy was that, if Iran were completely shut out of the market, prices could rise to $100. But since April, Iranian production declined by about 0.8 million barrels per day while OPEC and Russia increased production by an estimated 1.7 million barrels per day. With the increase in U.S. production, total supply rose by an estimated 3.0 million barrels per day.

The U.S. has become a net exporter of oil and oil products for the first time since 1949.

The United States has become a net exporter of oil and oil products for the first time since 1949. The boom in shale has made the country one of the world’s top oil producers. The first tanker of U.S oil exported to China has recently unloaded at Rizhao in Shandong province. Demand has been growing at a fairly steady pace and is likely to continue to do so in the absence of a recession.

Oil futures positions

Iran’s exports are falling, but not as steeply

The latest data suggest that oil exports from Iran are continuing to decline. According to tanker tracker data, Iran is now exporting about 1.1 million barrels of oil per day. In April, the country’s exports were close to 2.2 million barrels of oil per day. The U.S. reimposed sanctions on Iran in November but exempted eight countries from the bruising sanctions. The exemptions mean at least some supplies from OPEC’s third-biggest producer will keep flowing into international markets.

And in Canada, the province of Alberta imposed some cuts on output. If we combine our estimates of demand with these supply data, it is easy to see the numbers that shaped the OPEC discussions. If you strip aside everything about base levels, the deal, on paper, amounts to a cut of about 1.2 million barrels of oil per day. OPEC will cut about 800,000 barrels of oil per day, and non- OPEC will cut about 400,000 barrels of oil per day. Some of the countries will not meet their quota cuts, so Saudi Arabia will have to do the hard work. Saudi oil minister Al Falih said Saudi produced 10.6 million barrels of oil per day in October and 11.1 million barrels of oil per day in November, and will cut output to 10.2 million barrels of oil per day in January 2019. If this does happen, there may be some quota cheating elsewhere in OPEC, and the OPEC+ supply cut could easily reach 1.2–1.3 million barrels of oil per day. This would be enough to bring oil back to our fair value estimate.

We do think it is likely that prices will rise over the coming months as long as the current economic deceleration does not turn into a recession.

The United States. is a major marginal producer now. If prices fall, U.S. production is not going to grow much, if at all. If prices rise a lot, U.S. output can rise. The message the Saudis seem to be sending is that they want to stabilize prices at a level a bit higher than where they are now. How oil production in Saudi Arabia and the United States interacts will be the most important factor in determining how successful the Saudis are. But we do think it is likely that prices will rise over the coming months as long as the current economic deceleration does not turn into a recession.

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