The price of Brent crude oil closed last week at $62.71 after closing the previous week at $59.34, while WTI closed the week at $59.73 after closing the previous week at $56.85. During the last two weeks the price of Brent crude increased by 12.2% and the price WTI increased by 14.4%. Crude prices are now back to the range of the prices for much of 2019.
Where will prices go next? Will prices continue moving upwards like the run-up in prices that started in mid-2017 during which the price of Brent broke through $80.00 in Q3 of 2018? Or will the price of Brent crude struggle to move much higher? And what is the possibility of a significant price correction? After breaking through $80.00 in 2018, the price of Brent crude fell sharply back to around $50.00 by the end of 2018.
While Stratas Advisors has been bullish on oil prices since the Q2 of last year – the pace of the increases has outstripped our Q4, 2020 short-term (next 24 months) forecast, which forecasted that the price of Brent would approach $60.00 in the second half of 2021, and then continue moving upwards to $70.00 in Q4 of 2022. A similar pattern was forecasted for WTI with the price of WTI moving toward the mid-50s in the second half of 2021 – and then to the mid-60s by Q4 of 2022.
Certainly, a major part of the price rise stems from monetary and fiscal policies that have been put in place since early in the pandemic, and these policies will not be changing anytime soon.
- Last week, the Federal Reserve reiterated its accommodative monetary policy and its intentions to maintain the policy until full employment is reached and inflation has been running above 2.0% for some time. These policies include $120 billion monthly asset purchases of short-term treasure securities and mortgage-backed securities. It is now expected that these purchases will remain in place at least through the end of 2021. Also, there has been purchases of high-yield corporate bonds in the secondary market, but by the end of 2020, investments were only $14 billion of the $250 billion that was authorized for the program. The balance sheet of the Federal Reserve now stands at $7.37 trillion, which compares to $3.78 trillion in August of 2019.
- The easy money policies have kept interest rates extremely low with the 2-year treasury at 0.11% and the 10-year at 1.16%. Furthermore, the US high-yield corporate bonds have dropped below 4.0%, which is a record low.
- The M2 money supply (cash, saving deposits, checking deposits, money market securities and other sources of funds that can be easily converted into cash) increased by 25% in 2020, which is about four times the normal growth rate of M2.
- US corporate earning surprised to the upside with Q4 earning increasing at 1.7% year-on-year, which was a major surprise in that analysts were predicting a decline of 2.4%. More than 80% of the S&P had positive EPS surprises.
- The personal savings rate in the US has been running at around 15% since the middle of last year. As such, not only do US consumers have pent-up demand, but they also have significant sources of funds to support this future demand.
- Now that the US Congress has moved past the impeachment trial the US Congress will be focusing on passing the next stimulus/recovery package – and one that is of a scale of $1.9 trillion – and will be coming on the back of the $900 billion passed at the end of last year.
Obviously, all the above developments will provide support for higher prices – including prices of goods, equities, and commodities. However, there are factors that could disrupt the oil markets.
- One major surprise would be the failure of the US Congress to pass a stimulus/recover package in the range of $1.9 trillion – but that has a very low probability with the Democrats having control of both houses.
- US shale producers have not increased production since June of last year, even with the significant increase in prices. Stratas Advisors is forecasting that production increases will remain moderate over the next two years, but that is with the price of WTI staying below $60.00 during 2021 and not reaching $65.00 until Q4 of 2022. However, because the shale sector has a history of producing what it can (until the producers run out a money again) – instead of what the market needs for stable prices – overproducing is a risk. At this time, however, we think this is only a moderate risk, in part, because it will take time to ramp up operations. Furthermore, we think the sector will exhibit more caution and discipline with the sector maturing and the experience of the management teams going through the previous downcycles.
- The ongoing stability of the OPEC+ framework is required for higher oil prices. As we have been highlighting, maintaining the framework will be more challenging the higher that oil prices go. This risk is also related to the risk associated with the US shale producers, in that, if the OPEC+ producers see that US shale producers are increasing production, some of the OPEC+ producers will react by bringing on more supply and pushing down oil prices, since they will not be open to ceding market share to higher cost producers. We think this is a substantial risk and one with a significant probability of occurrence.
- Another risk pertains to demand, which has two aspects. One aspect is that the impact of the pandemic lingers – or even increases -- because of more deadly strains for which the vaccines will not be effective. The other aspect is the possibility that real structural changes have occurred with respect to demand, as the result of living with the pandemic – and even with the mitigation of COVID-19, demand will not come back to pre-COVID levels. While the potential remains that there will be another surprise associated with COVID-19, we think this is a lower risk at this time, given the availability of vaccines and the expectation that the supply chain-related issues will be resolved. With respect to the potential for structural changes – the most affected demand segment will be business-related air travel – which will return more slowly than the other demand segments – but we expect that business-related air travel will ultimately rebound and return to growth. We are expecting that the demand associated with the other demand segments will return to pre COVID-19 levels – and that this will occur for much of the world by Q3 of 2021. While there will be more flexible work arrangements for some, people will return to the workplace, and even when working from home, people are not static. It is highly unlikely that the basic human desire for mobility has been permanently changed by COVID-19.
Considering thefactors supporting oil prices and the associated risk, we think that the most likely path is that oil prices will be moderately higher in six months – but it will not be straight-up ride – and there is a real possibility of a price correction along the way with the price of Brent falling back to the $50.00 level.