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Why Oil Dropped Last Week – The Week Ahead

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Oil prices dropped precipitously on Thursday, leaving many scratching their heads wondering why. After all, the report from OPEC noting the effects of member non-compliance to production quotas was old news. Still, when OPEC reported its members’ production increased by 173K barrels a day as a result, to average 32.87 million barrels in July, many were still surprised. The United States Oil ETF (NYSE: USO) dropped 2.4% on the day, and was down 1.4% on the week because of it.

USO Chart 5-Day Chart USO

Oil dropped last week, but recovered some ground on Friday, with the United States Oil ETF regaining some 0.8% Friday. So where do we go from here?

Thursday’s catalyst that collapsed oil from its high point on the week, and while it was seemingly heading to new near-term heights, was OPEC’s Monthly Oil Market Report. The key data that did oil in was found within the world oil supply segment of the report, where OPEC notes July production actually increased by 173K barrels per day.

The reason for the increased production was foretold. OPEC member non-compliance to production quotas in July caused the damage, though we thought it was addressed for all the audience at OPEC’s meeting in Abu Dhabi – apparently not. OPEC members must adhere to the outlined plan or else OPEC loses all credibility and fails to serve its own cause, which is to balance the oil market and to improve profitability through better pricing.

Unfortunately, as media begot media on the bad news, and prices collapsed, many failed to note that the OPEC report for July was full of positives for the oil market. In fact, I would say there were far more positives than negatives, especially if OPEC has really gotten its act together with regard to compliance moving forward.

Among the positives I noted were important upgrades to the global economic outlook and world oil demand. World economic growth is still forecast at 3.4% for 2017 and 2018, but OECD growth has proved better than expected thus far in 2017, especially in the Euro-zone. OECD growth is seen at 2.0% this year and next. Uplifting the globe are India (+7.0% in 2017 and +7.5% in 2018) and expanded growth in Brazil and Russia this year and next. China showed better GDP than was expected so far this year, requiring an upgrade to the 2017 forecast to 6.7%. However, the pace for China is still seen sinking in 2018 to 6.3%; I think this is wrong, and expect we will see later upgrades to China’s 2018 pace to match that of 2017, thanks to improved USA and European demand for its goods.

Given stronger economic expectations globally, world oil demand growth has been upgraded by 0.1 million barrels per day in 2017, to 1.37 mb/d. As such, total oil demand is expected now to average 96.49 mb/d. For 2018, it’s expected to increase to a growth pace of 1.28 mb/d, with total demand averaging 97.77 mb/d. That’s really good news toward balancing the market. Make no mistake about it, though, I expect upgrades to the demand growth outlook to continue as a robust economic recovery takes hold globally, especially in the U.S. and Europe. There was some evidence toward that end provided in information on product markets and refining operations. Refinery margins in the U.S. made gains due to “healthy domestic demand.”

And while production increased out of OPEC in July, the news on the world oil supply front was not all that negative at all. In fact, Non-OPEC supply growth was revised down by 28K b/d to 0.78 mb/d, to 57.77 mb/d supply. The reason for the downward adjustment was weaker than expected output in OECD America in the second quarter. The supply growth forecast for the region for 2018 was also reduced. Drivers of growth are seen in the U.S., Brazil and Canada, against declines in Mexico, China, Columbia and elsewhere. But the news about the growth of OPEC’s production still sank the market.

Security 08-11-17
United States Oil (NYSEARCA:USO) +0.8%
iPath S&P GSCI Oil (NYSE: OIL) +0.8%
Energy Select Sector SPDR (NYSE: XLE) -0.7%
SPDR S&P Oil & Gas E&P (NYSE: XOP) +0.2%
Exxon Mobil (NYSE: XOM) -1.0%
Chevron (NYSE: CVX) -0.8%
ConocoPhillips (NYSE: COP) -0.4%
Phillips 66 (NYSE: PSX) -0.2%
Rice Energy (NYSE: RICE) +1.7%
Pioneer Natural Resources (NYSE: PXD) -0.9%
Cabot Oil & Gas (NYSE: COG) +0.1%
EOG Resources (NYSE: EOG) -0.7%
Chesapeake Energy (NYSE: CHK) 0.0%

Still, on Friday, oil prices recovered some of that lost ground, though energy stocks weren’t buying in yet. Importantly, OPEC is addressing the compliance issue, and Saudi Arabia stopped the bleeding with some commentary about OPEC possibly increasing production cuts. And, investors had to recall that robust demand for gasoline in the U.S., and reduced supply from OPEC, is driving strong draws from crude stores now in the U.S.; though the rig count increased last week.

Moving forward, the President’s statement regarding “military options” for Venezuela portend war, and put pressure on oil prices to the upside as well. Venezuela is a factor that should be gaining in weight in coming weeks for various reasons. Upheaval in the nation is impacting production negatively already, and may threaten in some manner the 1.9 mb/d of production currently reaching market. I’ll talk about this issue in greater detail in an upcoming report. Also, geopolitical vulnerabilities with regard to production were reminded to us when protestors stormed a facility in Nigeria last week. The market has gotten all-too comfortable with supply, a good portion of which is vulnerable to disruption.

In conclusion, as investors consider the positives moving forward for oil, including especially expanding economic activity, improving global demand, production vulnerability and the efforts of OPEC to tighten compliance of its members, oil should recover the latest lost ground and some. I expect oil to break toward and through the upper end of its recent trading range, through $60 before the close of this year. For more of my work on energy and other markets, readers are welcome to follow the column here at Seeking Alpha.

Disclosure: I am/we are long USO.

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.

Additional disclosure: My position is via options.



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