It is no easy task to predict the price of a commodity, any commodity. There are so many factors that go into the calculus of raw material values. Of course, supply and demand are the places to start. When supply is greater than demand, prices tend to go down, and when the converse is the case, they go up. In bear markets, the production cost is always a good target for prices on the downside. If the price of a commodity falls to a level where producers lose money, they tend to cut output. However, the science of production cost itself can be a complicated issue. Many times, governments subsidize production costs during bear markets as the raw materials are strategic necessities. Shortages in many commodities markets are too great a risk to take for political leaders who could be blamed for, say, limited availability of food or energy products.
On the upside, prices tend to rise to levels where demand declines and inventories build as producers increase output. Commodities are efficient economic assets, and their pricing cycle often is a model for an economics 101 class. However, commodities prices exist in a multi variable world where, political events, economic events, weather, acts of God, and other issues can influence prices in the blink of an eye. Additionally, speculative buying or selling in a market may affect prices in the short term and may even cause producers or consumers to act differently than they would have if the speculative element were not present. Those specs are a necessary evil as they provide liquidity to markets at all times and without them, there would be much more price variance in markets across all asset classes. I always look at price grand projections in commodities markets with a grain of salt.
When it comes to the world of crude oil, almost everyone has a prediction for the price of the energy commodity. Most recently we heard from two of the biggest banking and trading institutions in the world for their predictions, and each went in an opposite direction.
Goldman Sachs Vs. Citigroup – Who Will Prevail in Their Forecasts?
On July 9, Eric Lee a senior energy analyst at Citigroup told markets he expected the price of crude oil to head to the $60 per barrel level by the end of 2017. The reasoning for the bullish call for the energy commodity is that demand will drive it higher. Lee projects that demand will reach 97.3 million barrels per day (bpd) on average in 2017 which is a record high. In 2016, average daily demand was at 96 million bpd. The primary driver of the increase in consumption of oil comes from China and India. The reduction of around 700,000 bpd from OPEC should drive the price higher according to Lee. The analyst noted that OPEC cuts did not commence until the start of 2017, but speculators ignored that the cartel spent the final months of 2016 ramping up production so that the basis for the output cuts would come from a higher level. Meanwhile, the Citigroup analyst sees $60 as a target for the price by the end of 2017 and into 2018.
On the other side of the coin, Jeff Currie and Damien Courvalin, from Goldman Sachs told markets on July 10 that OPEC needs to “shock and awe” the oil market for the price of the energy commodity to move higher. The pair said that the cartel would need to increase output cuts to shrink the global glut and without a sustained decline in global inventories and U.S. production, the price of oil could slip below the $40 per barrel level. Additionally, Goldman Sachs pointed to increasing production from Libya and Nigeria in their report.
It looks like oil is now a 60-40 proposition when it comes to some of the most respected analysts on Wall Street these days. The average of those two numbers of $50 per barrel and that is the number I continue to believe is the critical pivot point for the price of the energy commodity. At around half the price seen in June 2014, $50 per barrel is a satisfactory level for the world’s consumers. Fifty bucks is almost twice the price we witnessed on Feb. 11, 2016, when oil fell to its lowest price since 2003 at $26.05 per barrel, so it is a level that satisfies the world producers. Therefore, my opinion is that the half century mark is a level that continues to be the sweet spot for NYMEX WTI light sweet crude oil.
The Indication From the Forward Curve Has Different Meaning Than in the Past
Traditionally, the forward curve or relationship of deferred oil prices compared to nearby prices has been a great guide when it comes to price direction. When contango or the forward premium increases, it has historically pointed to periods of oversupply. When the market moves towards backwardation, where nearby are higher than deferred prices, the tightness in the forward curve tends to indicate supply shortages that lead to higher prices. However, when crude oil moved above the $50 level in 2016 and remained there during a long period in 2017, U.S. shale producers took advantage of the higher price and hedged or locked-in prices via the NYMEX futures market by selling deferred futures contracts. Therefore, the selling along the forward curve caused contango to decline and backwardation to appear at some points along the forward curve. Source: CQG
As the chart of the December 2018 minus December 2017 NYMEX crude oil futures spread highlights, the spread moved into backwardation when the price was above $50 per barrel and contango increased during corrections to the downside. The most recent high in the spread at $2.31 per barrel occurred on June 21, the day that August crude oil futures fell to the lowest level of the year at $42.05 per barrel. The forward curve is in sync with shale producer hedging activity and as prices decline, the hedging abates, and contango widens. In another sign of the importance of shale hedging for the market, open interest in the futures market rose to a record high in May while oil was comfortably trading at the $50 per barrel level. Source: CQG
As the weekly chart highlights, the metric that measures the total number of open long and short positions in the NYMEX crude oil futures market rose to 2.315 million contracts during the week of May 10 while crude oil was still in the 2017 trading range from just under $44 to just over $55 per barrel. When crude oil broke through the bottom end of the range in late June, the metric declined as shale producers decreased their hedging activities. Both the forward curve and open interest statistics in the futures market have become excellent tools for monitoring the hedging activity for the growing oil production business in the United States these days.
While producer activity has slowed below $50 per barrel, demand for crude oil products has increased.
Processing Spreads Called the Bottom and Led the Rebound
Throughout 2017 I have been writing that the crude oil processing or crack spreads have had incredible predictive power when it comes to the path of least resistance for the price of crude oil futures. Rallies in the crack spreads have told us that demand is increasing while declines have pointed to the opposite condition throughout the year. In most cases, the price of crude oil has found tops and bottoms after crack spreads have reversed their price momentum. One of the reasons that I believe that oil is heading back to the $50 per barrel level is that demand for products remains strong and crack spreads have been making higher lows and higher highs since June. Source: CQG
The daily chart of the August NYMEX gasoline crack spread shows that the refining margin for gasoline has moved from lows of $14.64 on June 15 to highs of $20.91 on July 19. The summer season is the time of the year for peak demand for gasoline, so the rally in the spread has a seasonal component. However, the heating oil crack spread has also rallied since June which is a significant commentary on the demand for oil products. Source: CQG
The daily chart of the August NYMEX heating oil crack spread highlights that the demand for heating oil which is a proxy for other distillate fuels has increased since June. The spread rallied from lows of $13.51 on June 6 to its most recent high at $18.11 on July 19. Crack spreads fell to lows before oil reached $42.05 on June 21 and they have continued to rally fostering the recovery in the price of the energy commodity which was trading at north of $47 per barrel on the now active month September NYMEX futures contract on July 17. Crack spreads are telling us that crude oil is likely to move back to the $50 per barrel level.
OPEC Has Been Made Redundant
OPEC has lost its mojo, and the reason is the growth of production in the United States and Russia. The OPEC production cut was the result of intervention by the Russians who acted as mediator last year between the differing interests of Saudi Arabia and Iran. The Russians convinced the cartel to reverse their Saudi-led strategy of pumping oil to build market share to one that was more supportive for the price of the energy commodity. In their Vision-2030, the Kingdom of Saudi Arabia has decided to diversify their economy away from petroleum revenues via an IPO of Aramco which will capitalize their sovereign wealth fund for investments abroad. The world’s three leading producers of oil are Saudi Arabia, Russia, and the United States and the future path of the price of the energy commodity will be a result of production in these nations.
OPEC has become a toothless tiger and decisions about international oil policy for the future will not come from Vienna at their biannual meetings but from Riyadh, Moscow, and Washington, D.C. Rex Tillerson, the former Chairman, and CEO of Exxon Mobil (NYSE:XOM) is now the Secretary of State of the U.S. which is a sign of just how important energy policy is to the nation. Under the new administration and how the U.S. is not only a key cog in world oil policy but the world’s most important swing producer these days. The redundancy of OPEC began years ago, and technology has hastened the demise of the influence of the cartel.
Technicals Point to Solid Support at $42.05 Per Barrel
Meanwhile, Saudi Arabia is still a major player in the world oil market, and it is in their best interest for the price to move back to the $50 per barrel level given the upcoming IPO of Aramco in 2018. On July 17, the price of NYMEX September crude oil was trading around the $47.30 level above the midpoint of the recent lows and sweet spot $50 level. Despite the projection from Goldman Sachs, I believe there is solid support for the energy commodity at its June 21 low of $42.05 per barrel. While oil did make a new low for 2017 at that date, it only was able to manage a decline of 15 cents below the previous support which was at $42.20 — the November 2016, pre-OPEC cut level.
Crack spreads, the forward curve, and the politics of the international crude oil market all favor a return to the half century mark for the price of oil. This week’s inventory data from the API and EIA both support a higher oil price. While I believe that $50 is still the critical pivot point for oil and it is likely to remain at that level into 2018, it is possible that both Citigroup and Goldman analysts will wind up being right on their calls. It is possible that a push down to below $40 could occur if inventories do not decline at a rate that satisfies the market and $60 is possible if there are any “shock and awe” events.
However, the factors that could take oil significantly lower or higher are likely to be short-term events. In my opinion, both analysts set great levels for buying on the downside or selling on the upside if oil can manage to make them look good. Keep an eye on the XLE over the coming days and weeks as it is in dire need of a rebound after falling throughout the year. The energy index closed on July 19 at around the $66 level showing some signs of life, finally.
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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.