Oil Could Be Headed for a Price Spike...Or Maybe a Price Collapse

Two articles by Forbes contributor Michael Lynch looked at the potential for oil prices to spike or the potential for them to crash.

From the first article:

There is significant optimism about oil prices for next year given the return of inventories to something approaching “normal” levels, and a high degree of compliance among oil producers who have agreed to cut production. Strong economic growth should produce robust demand next year, and there is a relatively strong consensus that the market will be bullish for oil prices, with some talking about a $70 or $80 target for Brent. Compared to the swings of the last decade, a $10 or even $20 increase seems like a pittance, but would actually put $100 billion to $200 billion into the pockets of OPEC countries, and add tens of billions to the oil industry’s revenues. 

And numerous events could cause prices to move upward, including civil unrest in Venezuela or Libya, increased attacks on Nigerian producing facilities, disputes between the governments in Baghdad and Kurdistan, the re-imposition of sanctions on Iran, and technical problems at any number of large facilities around the world. 

But market tightness seems unlikely to cause a sharp increase in prices, since a number of producers would presumably take that opportunity to raise production. But one assumes that the Southwestern U.S. has seen new sightings of that 1980s bumper sticker, “God grant me one more boom and I promise not to screw it up,” a sticker that’s gotten more use than “Clinton for President.” Because it’s boom and bust, not boom and boom or boom and plateau, a basic fact that the industry and investors seem to forget.

How could it happen again? The four major modern price collapses —1986, 1998, 2008, and 2014— have each had a different cause, and provide some idea of what might cause another collapse next year. The first was the result of a market collapse — OPEC production fell by half from 1980 to 1985 — due to excessively high prices. In 1998, the market was not under such strong pressure, but most OPEC nations were exceeding their quotas, led by Venezuela, which proclaimed its defiance to the organization. A combination of short-term economic weakness leading to higher inventories and a determination by Saudi Arabia to rein in the errant producers led to the lowest prices in many years.

And from the second:

A recent post talked about how the oil price might collapse this year, and what factors would cause that. In this post, the potential for a price spike and what might be behind it will be enumerated. Because, as those involved in following oil markets have long known, almost any trend and price is possible—in the short run. 

Several decades ago, a reporter from a Swedish business magazine asked me to participate in a contest to predict the oil price at year’s end. (Okay, he didn’t really call me, he called the group I worked for and nobody else was around.) I wound up winning the contest, received a nice sweatshirt and an interview in the magazine to explain my success. However, when I told the reporter that I had basically guessed, since the short-term market is quite volatile and predicting political elements that affect the price impossible. The magazine never called me again. 

So, the market fundamentals suggest that prices will be tight this year, but a spike, that is, a sharp significant increase, rather than a gradual rise. Higher prices usually come from one of two sources: rapid demand growth in a tight market, or a significant disruption in supply.

Rapid demand growth could, theoretically, occur just as the result of a robust global economy, as in the rebound in 2010 (see figure) and the strong 2015 growth. Alternatively, there are a few short-term events that can cause demand to spike, as in 2004, when constraints on Chinese coal deliveries saw power companies rely on oil, sending that country’s demand up 1 mb/d for the year and reversing the bearish expectations for the year (double the previous trend). Few economies are large enough that an unusual event like that could affect the global market—unless it was very stressed already.

Lynch's conclusion? 

So, my expectations are for slight market tightening in the first part of 2018, but a likely decline due to slower economic growth, some quota cheating and strong shale oil production. But as the market moves into balance towards the 3rd quarter, the potential for supply disruptions to have a bigger impact will grow. Serious economic weakness could bring a collapse, but the political instability in Libya and/or Venezuela, with a tighter market balance, could see prices up above $70, maybe even $80. Ignoring (relatively) small probability events, prices will probably be slightly lower next year, but will the short-term trajectory is not random, it remains highly uncertain.

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