After oil’s wild ride from $100 per barrel in 2014 to $26 earlier this year, the oil futures curve is almost perfectly flat, with prices hugging $50 per barrel as far as the eye can see.
This, however, doesn’t mean that the oil market will be lackluster. While the futures curve suggests that market participants see $50 as being close to oil’s long-term equilibrium price, the options market doesn’t appear to believe that oil will actually spend much time being in equilibrium. Implied volatility on options are off their highs from February but about one-third above their five-year average (Figure 2).
The combination of the futures and options prices suggests that oil prices might range-trade for a very long time in an exceptionally wide channel. If the price of WTI is $52 one year out, and implied volatility is 40%, and one assumes log-normality, this suggests that one year from now, there is a 68% probability that prices will be between $34 and $76, and a 95% likelihood that they will be between $23 and $116 per barrel. If this is a trading range, it’s one that is wide enough to drive a truck through.
In the oil markets there is plenty of precedent for wide-trading ranges. The 2014-2016 oil price collapse is hardly the first such collapse in history. The previous oil-prices collapse, which reached its crescendo in late 1985 and early 1986, offers interesting lessons. Following that collapse, from $32 per barrel to $12, the market traded in a range for the next 14 years (Figure 3). From January 1986 to December 1999, oil prices averaged $19 per barrel, but the range was $10 to $41 per barrel. The $41 per barrel occurred after Saddam Hussein invaded Kuwait in the summer of 1990. With the exception of the Persian Gulf War, oil prices never exceeded $28 per barrel.
Futures and options markets are currently pricing an analogous scenario, with the range shifting upwards. Instead of averaging $19 per barrel as they did during the late 1980s and 1990s, oil prices suggest an average just above $50 per barrel between now and 2024. If this comes to pass, one might expect a similarly wide range. It’s possible that the recent low of $26 per barrel could be the low end of the range. If so, the high-end of the range could still easily be $80 per barrel, and perhaps over $100.
What could cause oil prices to fluctuate in such a wide range? For starters, both supply and demand for oil are notoriously inelastic, so small perturbations in supply or demand can produce outsized moves in prices. There are numerous upside and downside risks to oil prices. Here are a few of them:
- China: Commodity markets have taken heart recently that China isn’t slowing as much as feared, but it may still be premature to pop the cork and celebrate. China has extremely high levels of debt. Public plus private sector debt adds up to over 250% of GDP, and China is trying to solve a problem of excessive debt by issuing even more debt. When Japan, U.S. and European debt levels achieved similarly high levels, financial crises, recession and slow growth followed. Moreover, government stimulus programs produced only modest effects. If China slows down, it could take commodity markets down with it, including oil.
- Emerging market demand: Nations from Brazil to Russia are mired in recession. Moreover, many oil producers are cutting back budgets, including subsidies to domestic oil consumers. This could hamper demand growth in places as diverse as Nigeria, Saudi Arabia and Venezuela.
- Storage: Oil storage levels continue to grow and are up about 12% year on year, and oil storage remains close to record highs. What this suggests is that despite an extended period of lower prices, demand is still not keeping pace with supply (Figure 5).
- More efficient cars: The average vehicle sold in 2016 consumes about 15-20% less gasoline per unit of distance than a vehicle sold in 2007. As such, even if people drive more in response to lower energy prices, it doesn’t necessarily mean that oil consumption will rise as quickly as the number of miles or kilometers driven.
- OPEC members are unlikely to cooperate: Saudi Arabia and Iran don’t even have diplomatic relations and are at loggerheads in numerous Middle Eastern conflicts ranging from Syria to Yemen. It’s hard to see what incentive the Saudis or their close allies in the Gulf Cooperation Council would have in cutting back production to support world prices. Doing so would only be to the benefit of Iran, Iraq (which is largely within Iran’s sphere of influence), Russia, Venezuela and frackers in the U.S.
- U.S. production is declining: An increase in U.S. production from five million barrels per day in 2008 to over nine million by 2014 played a pivotal role in the collapse of global oil prices. No other nation has had a comparable increase in production. However, U.S. production is now declining. During the week of May 20th, the U.S. produced 8.7 million barrels per day, down 9% from its peak, according to data from the Energy Information Administration (EIA) (Figure 6).
- Investment has collapsed: The number of operating oil and gas rigs has fallen precipitously (Figure 7). Even taking into account the strong increase in per-rig productivity, this implies a strong likelihood of continuing declines in U.S. production in the near term.
- Geopolitical risks: Saddam Hussein’s invasion of Kuwait in the summer of 1990 is the quintessential example of what geopolitical risks can do to oil markets. After having gone deeply in debt to finance his seven-year long war of attrition against Iran (1980-87), Saddam became even tighter on funds following the 1985-86 collapse in oil prices and needed all of the revenue that he could get. When an oil-drilling border dispute with Kuwait couldn’t be solved to his satisfaction, he made a desperate gamble and decided to invade his neighbor. While this particular situation is unlikely to be repeated, the collapse in oil prices is adding significant budgetary strains a diverse set of oil exporters, including Algeria, Angola, Nigeria and Venezuela. Even the Saudis are tightening their belts. Instability in any of these countries has the potential to send oil prices soaring. The Gulf monarchies still have a substantial cash cushion that should allow then to live with $50 per barrel oil for several more years without too much trouble. Other nations, however, lack such cash reserves and could be more vulnerable to upheaval. (Figure 8).
- At $50 per barrel, the market appears to see risks as being evenly balanced but with a big potential for both upside and downside swings in prices.
- Any sharp rally in oil prices could be met with additional supplies coming on line from the U.S., perhaps in fairly short-order.
- The real swing producer is the U.S. If prices fall, American producers will have to cut back. If prices rally, they can quickly move rigs back on line and begin ramping up production.
- Saudi Arabia has the potential to be a swing producer, in theory, but is constrained by the threat of fracking technology and by its regional disputes with Iran not to actually use its power to move prices upwards. As such, it will probably produce as much oil as it can in order to maximize short-term and long-term revenues.
- Given the potential for wide swings in oil prices, hedging can be just as important during a period of potentially volatile range-trading as it is during secular bull or bear markets.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the authors and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.