Jan 12, 2018 | 19:47 GMT

5 mins read

The Slippery Task of Balancing Supply and Demand in the Oil Market

A gasoline pump in London. Oil prices are up 59 percent since 2017 lows in June.
  • A number of factors including increased demand and continued production cuts are contributing to the rise in Brent crude oil prices.
  • Russia and many OPEC members view higher prices with cautious optimism. They've tried to curb production enough to keep oil prices stable without curbing it so much so as to direct investment to North American shale oil production or alternative energies.
  • There are conflicting views about how much U.S. production has actually increased and how sustainable the increase is, but many producer countries remain concerned. 

The price of Brent crude oil topped $70 per barrel briefly Jan. 11 for the first time in more than three years. The rally in oil prices, which are up 59 percent since 2017 lows reached in June, has been driven by a number of forces, including increased demand and continued production cuts. Though breaking through the symbolic $70 price level for the international benchmark is music to the ears of some producers who have cut output, higher oil prices are both a blessing and a curse for Russia and many OPEC members that have sought to curb production to keep oil prices relatively stable without causing them to increase so much that they boost investment in North American shale oil production and alternative energies.

The Rationale for Production Cuts

When Russia and Saudi Arabia and its OPEC allies began limiting output in January 2017, their main goal was not necessarily to increase oil prices above $70 or even $60 per barrel, but to reduce global oil inventories. Between late 2014 and early 2017, Saudi Arabia, Russia and others boosted production to reduce the price of oil and thus undercut shale oil production in North America by making it unprofitable. The global supply of oil exceeded demand by as many as 2 million barrels per day and inventories swelled. Commercial crude oil inventories in the United States at the start of January 2017, for example, were 48 percent higher than they were at the start of January 2014. To stabilize the oil market and stop prices from continuing to fall, a change in strategy was needed and many producers cut their production.

The new strategy has worked, to a certain extent. But it remains a work in progress. As 2018 gets underway, commercial crude oil inventories in the United States remain 28 percent higher than they were four years ago. This week, Suhail al-Mazroui, energy minister to the United Arab Emirates, noted that global stockpiles are more than 100 million barrels above their five-year average. Therein lies part of the challenge: Producers want to shrink oil inventories, but the market's price may have increased too quickly in response. When Brent oil prices broke even $60 a barrel ahead of a meeting in November during which producers agreed to extend production cuts to increase prices, several OPEC delegates, such as Iranian Oil Minister Bijan Zanganeh, expressed concern that higher prices might be counterproductive, a sentiment shared by Saudi Energy Minister Khalid al-Falih.

Why Prices Have Increased

There are several reasons why oil markets have tightened. During the first half of 2017, the cuts made by Saudi Arabia, the United Arab Emirates, Russia and others were significantly offset by rising production in Libya and Nigeria. By the end of the year, however, structural limitations caused Libya's and Nigeria's production to peak. At the same time, Venezuela's economic and political crisis continued to wreak havoc on its production capacity, with production falling to levels not seen since 2002. In December alone, production fell by an estimated 100,000 barrels per day to around 1.7 million. Moreover, the United States has increased pressure against Iran, a major oil producer, and there remain concerns that the United States may not extend sanction waivers.

On the opposite side of the market, demand continues to be robust, driven by worldwide economic growth. On Jan. 9, the World Bank increased its global economic growth estimates for 2018 to 3.1 percent after growth in 2017 was stronger than expected. However, this expected economic growth could be curtailed by any number of events. Two points of particular uncertainty are the U.S. trade enforcement plans against China that Washington is expected to unveil later this month and the direction NAFTA negotiations will take. 

The U.S. Role

Nevertheless, higher oil prices will make investment into U.S. shale oil more attractive. West Texas Intermediate, the U.S. benchmark, has been trading over $60 per barrel for several weeks now. At these prices, shale oil production becomes more economical in more areas. By many estimates U.S. production is set to take off this year — which is concerning for many other producer nations. Between January and October 2017, U.S. production rose by 812,000 barrels per day, according to the U.S. Energy Information Administration (EIA). On Dec. 9, the EIA estimated that U.S. crude oil production could average 10.3 million barrels per day in 2018 — record levels for the United States and roughly 1 million barrels per day higher than estimated 2017 figures.

There are conflicting views about how sustainable the increase in U.S. production is, and to what extent it actually exists. Some observers have argued that the vast majority of the production increase has been in the form of natural gas liquids or condensates — lighter hydrocarbons that include propane and butane when refined. These liquids are less valuable than gasoline and diesel to refiners and largely are destined to the export market, where they are sold relatively cheaply. Natural gas liquids and condensates could be one reason why, despite the recent rally in oil prices, the number of active rigs drilling in North America actually has declined over the past six months.

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