A Crude New Day
While not as pronounced as the typically negative correlation with the dollar, there is a normal relationship between equities and crude oil that seemed to have kicked in during the recent rally and correction (see “Crude & equities get reacquainted,” below).
“[Crude] has been in one of the widest discounts to the stock markets since the beginning of the financial crisis,” Flynn says. “We think that the spread is going to come in. There are a lot of people using the “bubble” word when it comes to crude oil; they are absolutely wrong. We are in the situation where the global demand is outstripping the production and that is going to keep us in a tight market for some time.”
At times crude oil can be a proxy for global growth. While there are countless fundamental factors on energy markets, crude oil is the fuel of growth. And while the stock market has been in a bull market since the 2009 bottom, much of that strength was attributed to Federal Reserve policy rather than economic strength. In 2017, that appears to have changed. The recovery stood on its own buoyed by less regulation and promises of tax cuts, and perhaps, more importantly, expanding out globally.
The crude rally had the winds of a sharply declining dollar and strong equity market at its back. This can be illustrated by the fact that all three markets corrected at the same time in February.
Where to Now
So what is apparent is that OPEC cuts, reduction in inventories, a bull global equity market and a return in global demand all had a hand in crude breaking out of its long-term range. The question is, how high can it go? With crude above $60, shale production will continue to ramp up and producers may also consider longer-term offshore projects.
“ExxonMobil wants to triple its shale output during the next seven years,” Marella says. “The price is ripe to do more. We are going to be stemming this rally and not touch $70. We are going to stay between $55 and $67. At those levels it is still profitable for everyone involved. “
Chirichella says crude will test support in the $55 to $57 range. “It will be a while before it goes in a sustained uptrend. The [February] equity decline was a correction but I don’t think we are going to wake up in two days and be back at the highs. Some technical damage has been done and it is going to take some time for this to clean-up,” Chirichella says. “We are heading into a consolidation period. Drilling rigs are going through the roof, production is going through the roof, demand is rising, but I don’t see it rising fast enough. I’m not bearish, but I am not wildly bullish anymore.”
Flynn, however, says demand will outpace what he describes as an inflated notion of increasing supply.
“Oil prices are going to average $75. It could trade above $80,” Flynn says. “Global demand is going to exceed production increases and we are in a supply deficit. We are consuming more oil on a daily basis than we are producing; that is going to draw down global inventories, which have been falling at a record pace. We have seen record drawdowns in inventories and that is going to takes its toll.”
While other analysts say that crude has traded in a $40 to $55 range for a $55 to $70 range, Flynn expects more. “We are in a new super cycle in crude oil. The shale production, while it is a very important part of the global production, is still going to be a small percentage of daily oil production, and traditional oil projects that have been canceled are going to be missed,” Flynn says. “Future projects are not going to be there when the demand rises. It takes years before we see that production come into play.”
Chirichella, however, expects large projects to move ahead. “Money is being spent. They are starting to find oil. There [recently] was a $100 million auction that took place in Mexico for offshore drilling,” Chirichella adds. “I think $50, $60 and $70 oil is getting some of those deepwater projects starting to look interesting again.”
He adds that a great deal of efficiency in production has brought down the cost of some of these projects. And Kuklinski points out that the reduction in regulations and taxes by the new Administration also brings down the cost of production.
Flynn says that prices haven’t rallied to a level where producers will feel comfortable spending on massive offshore projects, noting that many were burned in 2015 when they began ramping up production when crude rebounded above $60 only to make new lows a few months later.
Rotman expects crude to maintain a broad range of $55 to $75 for the rest of 2018. “I don’t see it going much higher than that, and I don’t see it going much lower than that. The days of $40 oil are over, and the days of $100 oil are over.”
Marella adds, “We can stay at these higher levels. We are in a stronger market, but a raging bull market, ‘no.’ We will trade down to the $57 level.”
While Chirichella thinks crude has made a significant high, he doesn’t necessarily think the high is in for the year. “Demand growth is going quite well. Demand is there I just don’t think it is going to be strong enough to offset supply by enough to get the world back to a balanced position. It could stretch through this year.”
So, the crude oil market appears to have come full circle. Increased production followed by OPEC’s decision in 2014 to produce at 100% capacity to punish higher cost producers and wage a market share war led to a huge sell-off. They chased higher-cost producers out (bankrupting some) but others discovered efficiencies that allowed them to compete. The high inventories persisted for several years, but a growing global economy has helped to reduce the overhang and is bringing supply and demand into greater balance.
The new, new normal just looks normal; a struggle between supply and demand. Both appear to be on the rise.