5 mins readCrude oil pricing model – modelling supplyHow is the world equipped to handle an additional 1.29 million barrels per day of demand in 2019? We once again turn to OPEC\u2019s December 2018 monthly review. OPEC breaks down supply across non-OPEC and OPEC suppliers.Non-OPEC supply in 2019 is likely to grow by 2.16 million barrels per dayto 62 million barrels per day as per December 2018 figures. Compare this with 2.5million barrel per day of growth booked in calendar year 2018 from the samesources. Growth in supply from non-OPECsources is slowing down but it is still running at 3.6% a year. Keep this figure in mind. This is a group that has noincentive to align its production strategy with OPEC. It may benefit from anOPEC coordinated supply cut but these producers cannot curtail production atshort notices.Often because of operational reasons and in case of US shalebecause of liquidity and cash flow concerns. When oil prices decline this group has an even stronger incentive topump more oil to meet their cash flow requirements. Consensus across recentindustry studies is that marginal cost of producing a barrel of at operationaltight oil wells in the US has dropped by 40% in recent years. An efficientshale producer in the Permian basin can now make money with oil prices hoveringin the lower $40 a barrel range. The Dallas Fed energy survey (March 2018)indicates breakeven prices at the most efficient producers are now as low as$25 a barrel leaving ample room for profitability at the $45-$50 price level. Figure 8. Breakeven cost for US functioning wells. Source Dallas Fed March 2018 survey. Figure 9. Non-OPEC crude oil production, source OPEC December 2018 monthly review.Of the projected growth above, 1.7 million barrels per day(79%) is likely to come from producers in the US. Of that 79%, 1.17 millionbarrels per day in additional production will come from shale oil. The industrystill has some logistical issues to resolve especially around pipelinecapacity. Lower prices for crude oil are likely to lead to highervolumes of production, not less by US producers. New wells may be put on holdas prices hold below $50 per barrel. There are some pipeline constraints thatare expected to ease towards the end of 2019 which will also reduce pricepressures (logistics discounts) on some US and Canadian producers. US Rig countmay fall but as we saw earlier in 2016 with lower rig count, rig productivity tendsto rise across US fields. OPEC understands this and has responded. In its December2018 meeting OPEC announced planned production cuts of 1.2 million barrels perday for the first six months of 2019. December quota for cuts was 800,000 barrels per day with Saudiproduction cuts estimated to range between 400,000 to 460,000 in December. TheKingdom added a little over a millionbarrels per day of supply post June 2018 in anticipation of US sanctions onIran. They now plan to partly reverse the production surge. The cuts however exclude Libya (likely to addback stalled production due to field and pipeline security issues) and haven\u2019tfactored in resumption of supplyfrom fields in Kirkuk in Kurdish Iraq. Despite the size of cuts Saudi Arabia will still end up withhigher output when compared to Saudi production levels at start of 2018. Sameholds true for announced Russian production cut of 230,000 barrels per day.December 2018 Russian production stood at an all-time high of 11.49 millionbarrels per day. While the cut may bite, the bite is a lot less than what theygave away in 2016. OPEC\u2019s smaller members can see through the optics of thecuts. The most likely results of this bit of hand waving is likelynon-compliance on part of smaller OPEC members. As Saudi and Russian cuts takehold, price will adjust briefly but the supply glut will not disappear. Thereare also questions about Russiancompliance with the cuts based on their historical behavior. Dallas Fed\u2019senergy charts for instance indicate that markets will reach balance somewherein 3Q of 2019. Goldman Sachs in its January \u201919 oil update also agrees that therewill be ample supplyin markets for the first two quarters of 2019. All this is with the expectation that the demand side ofthis equation will behave. However, any disappointing news coming out of China,US or India is likely to impact prices and create additional pressure on bothOPEC and non OPEC members to push production higher to meet revenue quotas.Noise, bias and opinionsWhilethe three don\u2019t impact or move prices, they do shape perceptions and conversations.Opinions on direction of oil prices can be classified in three broadcategories. a) Prices are heading south in 2019. 2019 year isgoing to be a repeat of the slump oil prices faced in 2015-16-17. Analysts whoopt to sit on this side of the table are rare these days. b) Prices have finally found their true level. Pricesare going to be range bound between low forties and high fifties for next twoyears (2019-20). Not as rare an opinion as (a) above but still not common. c) This is just a temporary year end correction. Ashedge funds book their losses or gains and close their trades markets willadjust upwards beginning January 2019. Celebrate as much as you want now butbetween OPEC cuts and limited buffer of spare capacity prices will head northagain in 2019. This is the most common view in news and opinion pieces as wehead into the new year. The opinion you favor is a function of data you are lookingat, news sources you follow and the particular brand of cool aid you favor.There is no directed intent to misguide or mislead the world, it just how yourmodel is put together. OPEC member countries. If you are an employee of theministry of energy, petroleum products or planning at any of the OPEC membersyou are likely to belong to the third school. Rising oil prices make your jobeasier and your budgets hold true to their planned levels. Your national interestand your OPEC strategy would be focused on actions that would push oil priceshigher. More dollars per barrel imply more dollars in the sovereign wealth fundand room to breathe on the current account front. It is also going to bedifficult arguing with your Minister\u2019s optimistic outlook on prices. Trading desks. If you are a member of a commodityresearch or sales and trading desk at a leading investment bank or researchhouse, your opinion is going to be a function of your trading positions.Traders have a four-hundred-year history of talking up their positions. Theydon\u2019t necessarily do it maliciously but their positions reflect their worldview. Right or wrong the world view seeps into conversations. While researchfunctions do independent work and are strictly regulated it is difficult toignore powerful opinions and quite often fairly logical arguments in favor ofthe original trade. Groupthink is a difficult force to resist. Hence if you areshort oil, you are likely to support thesis (a) above. If you are long (c) isyour game. If you have bet on short term volatility you would be happy with(b). If you are in neither of the first two camps, have a strong dislike for OPEC, would prefer global economic growth over a similar downturn, are essentially a perennial optimist or simply like lower fuel bills you would be rooting for option a) or b).Think through the impact of the same opinions when it comes to planning annual budgets at the largest crude oil producers in the world. If we expect balance in prices on account of already announced production cuts, would we factor in the impact of additional production cuts if required. We know that the Kingdom of Saudi Arabia does, but what about the other 5 producers on that list.