We’ve previously discussed some of the many factors that influence oil and gas prices – geopolitical events, the value of the dollar, OPEC – all of which are important and from time to time significant. At times, though, in seeking to understand oil and gas prices, we should remember the common formulation of Occam’s Razor – “the simplest explanation usually is the correct one.”
In the realm of oil prices, the simplest explanation is that oil prices largely are a function of supply and demand.
In recent weeks, oil prices climbed above the $50 price point largely as a result of OPEC’s “agreement” to cut production. Now, however, there are some renewed concerns about the future price of oil because of the basic supply and demand calculus.
First, the OPEC production cut, even if honored by all of the member states (which seems doubtful), may be more illusory than real. Prior to the production cut agreement, many OPEC members had significantly increased their production so that the production from which they would apply the agreed upon production decreases would be artificially high. In other words, the net result of the production “cuts” may not be much of a decrease in production at all.
Second, even if there are production cuts from the OPEC nations, and others including Russia, those cuts may well be offset by increased domestic production. Last week, the Baker Hughes report on US rig counts showed that domestic operators added rigs for the 10th consecutive week. Further, an analysis from Barclays predicted a rise in rigs from the current 529 rigs to 850 to 875 by the end of the year – an increase of more than 25%.
Simply put, the increased number of rigs will lead to increased production. Unless there is a countervailing increase in global demand, it is not too hard to imagine a somewhat muted return to the over-supply problem that lead to $30 oil in 2016. While few experts seem to expect a return to those price levels, it may be unrealistic to expect short term prices to rise much beyond present levels if rig counts and domestic production continue to increase.
More supply usually does not lead to higher prices. The simplest explanation often is the correct one.