In recent weeks, most of the focus in energy markets has been on the Organization of Petroleum Exporting Countries (OPEC), most of whose members agreed to cut production by 4.5-5.0%. The accord sent the price of oil soaring 9% in a single day and a further 4% over the next several sessions.
While the OPEC decision is undoubtedly important – it resulted in West Texas Intermediate crude oil futures having the biggest-volume day ever — it is not by any means the only important supply factor that will influence energy prices going forward. Since 2008, the United States has joined OPEC nations such as Saudi Arabia as a key swing producer and it is possible that the U.S. energy industry is gearing up to produce more oil.
Since hitting bottom in late May, the number of active U.S. oil rigs has risen more than 60%, according to energy services company Baker Hughes, albeit from an exceptionally low level (Figure 1). This may portend higher U.S. production, which could help to offset any decline in OPEC production.
In fact, U.S. production has already begun to increase. After falling from 9.59 million barrels per day (bpd) in April 2015 to 8.43 million bpd in early July 2016, production has since risen to 8.79 million bpd by early December 2016 (Figure 2).
Rising U.S. production might limit the upside on oil prices. Moreover, a further rise in oil prices will incentivize more drilling, thereby increasing production. If U.S. production hypothetically returned to its peak, it would offset 0.9 million of OPEC’s proposed 1.2 million bpd production cut that began January 1. Additionally, it’s not clear how closely OPEC would adhere to its production cut. Under the terms of the agreement, it’s up to Algeria, Kuwait and Venezuela to monitor compliance. Countries like Saudi Arabia have traditionally kept to their word, but countries like Iraq, whose production is highly decentralized and has a weak central government, might face difficulty controlling domestic production. As such, OPEC’s actual production cut may end up being considerably less than 1.2 million bpd, which is about 1.3% of world production.
A key test is whether crude oil can decisively break past $55 per barrel – rallies in June and October 2016 failed. However, a rally above that level might allow for a recovery to $60 per barrel or higher (Figure 3). In the short term, this would be great news for beleaguered oil producers, energy stocks, and currencies such as the Canadian dollar and Russian ruble. Longer term, however, it could incentivize a big spike in U.S. production.
Another hurdle for energy prices is likely to be inventories. Although the U.S. is the only country that publishes up-to-date information on inventories, U.S. data suggests a market that is awash in supply. Inventories remain near record highs and are still growing on a seasonally-adjusted basis at 7% year on year after a 35% rise in 2015 (Figures 4 and 5).
As such, while a continuation of the post-OPEC rally is a possibility, a long-term bull market might be a difficult case to make.
Following the OPEC meeting on November 30, implied volatility on crude options has plunged from above 40% to around 33%. It’s now near the lower end of its post-2014 range (Figure 6). OPEC appears determined to prevent excessive volatility and, especially, a return to the $26-per-barrel low notched early last year. A more stable oil price might, however, boost investment spending in the United States, at least from producers who are able to live with $50-per-barrel oil.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author(s) and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.
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