WTI oil prices plunged to almost $45 per barrel yesterday (Figure 1). That was a downward adjustment to where prices should be based supply, demand and inventory fundamentals.
Analysts invent narratives to explain why things happen after we already know the answer. In this case, oil prices fell supposedly because of falling confidence that the OPEC production cuts are working, fears of increasing U.S. shale output, and weakening demand from China.
Figure 1. Oil Prices Are Testing a $45 Floor. Source: EIA, CBOE, Bloomberg and Labyrinth Consulting Services, Inc.
None of those factors is new nor did they seem to affect the market a few weeks ago when prices were above $53 per barrel.
The real reason that oil prices have fallen is that they were too high and needed to adjust downward. Comparative inventory analysis (Bodell,2009) suggests that the correct price for WTI right now is about $45 per barrel (Figure 2).
Prices rose from that level in November 2016 to almost $55 (black arrows in Figure 2) following announcement of OPEC production cuts. Approximately $10 of “OPEC expectation premium” was included in those higher prices.
Figure 2. $45 Is The Right Price For WTI Based On Comparative Inventories. Source: EIA and Labyrinth Consulting Services, Inc.
In February and March, prices fell from more than $54 to $47 per barrel in the first deflation event shown in Figure 3. Prices then increased to more than $53 in the first half of April before falling to almost $45 per barrel this week during the April-May deflation.
Figure 3. Deflation of the OPEC Expectation Premium. Source EIA, Bloomberg and Labyrinth Consulting Services, Inc.
Deflation of the OPEC Expectation Premium. Source EIA, Bloomberg and Labyrinth Consulting Services, Inc.
There is little doubt that the OPEC cuts are real and are working to reduce global inventories. Unrealistic expectations about how quickly markets might re-balance created an expectation premium that is now being deflated as prices adjust to where they should have been all along.
This market has been largely optimistic over the last year so it would not surprise me to see a return to $50 oil prices in the next week or so. At the same time, look for continued price volatility in the tug-of-war between revived expectation premiums and market fundamentals. Inventories will be the critical factor.