What Will Drive The Next Oil Price Crash?

Authored by Tsvetana Paraskova via OilPrice.com,

As we roll into 2018, analysts and investors are more optimistic that the oil market will further tighten next year and support higher oil prices, but rising U.S. shale production will likely cap any significant price gains.

On the demand side, expectations are that global economic growth will support solid oil demand growth.

On the supply side, Venezuela’s dire situation, possible new sanctions on Iran, and increased tension in the Middle East mostly with the Saudi-Iran issues and the Iraq-Kurdistan standoff may take more barrels off the market than OPEC and friends plan, and send geopolitical jitters through the oil market.

However, according to energy policy expert Michael Lynch, there remain three potential events in the markets that could send oil prices tumbling. These include a large correction in the U.S. stock market that could spread to a sell-off in commodities; one of the OPEC members or Russia breaking away from the unusually strong compliance to the cuts we have seen so far; and U.S. oil production rising so much as to make OPEC see it as a threat to its long-term oil market share.

In markets, there are already some signs that we may be seeing some bubbles, Bitcoin being the most likely candidate, according to Lynch. In addition, the price to earnings ratio of the S&P 500 index is now over 25, well above the mean historical average of just over 15.

Last week, Fed Chair Janet Yellen said, referring to the high valuation in some asset classes, “the fact that those valuations are high doesn’t mean that they are necessarily overvalued.” According to VTB Capital’s Global Macro Strategist Neil MacKinnon, the ultra-low volatility in U.S. equities this year is “very vulnerable” to shocks, and current stability could actually bring future instability.

According to Lynch, if the U.S. market moves into bear territory next year with a big correction, it could spread the financial contagion to commodities such as oil.

Another potential threat to oil prices is that of an OPEC/non-OPEC pact participant beginning cheating outright—Iraq and Russia, for example—which could lead to the Saudis deciding to let the price of oil drop, Lynch argues.

Yet the Saudis have little choice but to support oil prices because of their heavily oil-reliant economy and the planned IPO of Saudi Aramco, Amy Myers Jaffe at the Council on Foreign Relations wrote in the Houston Chronicle last week. According to Myers Jaffe, if Russia makes a U-turn and boosts its oil production, the ultimate battle for market share will be between the U.S. and Russia, despite the fact that Saudi Arabia continues to hold influence in the oil policy of OPEC and its partners.

“For now, Russia seems content to collaborate with Saudi Arabia on oil market stability, which ironically also suits the current U.S. administration, whose America-first jobs message is tied heavily to the economic engine of the shale revolution,” Myers Jaffe said.

The shale revolution and the rise of U.S. oil production is the third possible factor that could lead to an oil price collapse, Lynch argues. If OPEC sees that it needs to defend market share in the long run, chances grow that the cartel may decide to let oil prices drop, Lynch says.

OPEC is now outright acknowledging that U.S. shale outperformed initial expectations, and last week the cartel revised up its projections for non-OPEC supply growth for this year and next.

The International Energy Agency (IEA), for its part, said that while OPEC producers had decided to roll over the production cuts to the end of 2018, non-OPEC supply would increase more than previously expected, and total supply growth could exceed demand growth next year.

The EIA forecasts in its latest Short-Term Energy Outlook (STEO) that total U.S. crude oil production will average 9.2 million bpd this year and 10.0 million bpd in 2018, which would mark the highest annual average production, surpassing the previous record of 9.6 million bpd from 1970.

OPEC is well aware of the second U.S. shale resurgence, and it looks like it’s currently sacrificing short-term market share in the name of higher oil prices—or “oil price stability”, as it loves to call it. As for letting the price of oil slide, OPEC members’ budgets may currently need higher oil prices even more than some U.S. shale drillers do.

While many analysts and OPEC expect the oil market to finally rebalance at some point in late 2018, a sharp correction in the financial markets, a dip in OPEC/non-OPEC compliance, and the market share wars could result in lower oil prices, or in the extreme case—in an oil price crash.

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