Sometimes in global financial markets, change can be brutal as market participants adjust to a completely new reality. The second half of 2014 was one of these periods and witnessed the beginning of what would become one of the largest declines in global oil prices on record.

For many years, markets had focused on 'peak oil', whereby escalating costs of production as new oil deposits became harder to source and rising levels of depletion meant that an increasing amount of production would be needed each year to keep overall supply unchanged.

In the International Energy Agency's (IEA) 2008 World Energy Outlook, it published for the first time a study of depletion rates in the top 800 global oil fields. It concluded that depletion rates had risen to 5.1% p.a. from 4.5% a few years previously and forecast that this would continue to rise over the coming decades. This meant that the global oil market balance would naturally tighten every year by 4-5m b/d (million barrels per day) and the IEA report concluded that, "it is becoming increasingly apparent that the era of cheap oil is over."

However, in the background, a technology, which was initially discovered in the mid 19th century, was already gaining traction: hydraulic fracturing. The US shale oil revolution crept up on markets in the following years and then rapidly accelerated from 1.2m b/d in 2010 to a peak of 5.36m b/d in March 2015.

Chart 1: US Shale Oil Production (m b/d)

Chart 1: US Shale Oil Production (m b/d)

Source: US Energy Information Administration (EIA)

Saudi Arabia reacted to the shale oil revolution with a well-publicised strategy, increasing production into an already oversupplied market and driving oil prices sharply lower. This is a critical difference between the recent oil price slump and historical episodes, that this one is clearly supply-driven, rather than being caused by declining global demand. In fact, after dropping to 84.8m b/d in the 2009 financial crisis, demand is forecast to have increased by over 9m b/d by 2016 to a record 94.2m b/d.

Chart 2: World Oil Demand (m b/d)

Chart 2: World Oil Demand (m b/d)

Source: OPEC (January 2016 Oil Market Report)

Furthermore, demand growth is widespread and strongly responding to lower prices. For instance, in January 2015, OPEC expected 2015 global demand to grow 3.6%, or 1.15m b/d, but by the end of that year it increased the forecast to 1.53m b/d. Its current forecast for 2016 is for an additional 1.3m b/d of demand, but with the IMF expecting global economic growth to accelerate in 2016 to 3.4% from 3.1% in 2015 and with oil prices at such low levels, that forecast could well once again prove conservative. It is noteworthy that one important source of incremental demand is China's effort to increase its strategic petroleum reserve — the capacity of which is expected to double this year — and could lead to total incremental demand from that country of 70-90 million barrels in 2016.

Oil DemandChange
20142015201620150216
Americas24.224.524.80.30.3
(US)19.419.820.00.40.3
Europe13.413.613.60.20.0
Asia Pac8.28.18.0-0.1-0.1
Total OECD45.746.246.40.50.2
Other Asia11.411.812.10.40.3
LATAM6.66.66.70.00.1
ME8.18.48.50.20.2
Africa3.83.94.00.10.1
FSU4.64.64.60.00.1
Other Europe0.70.70.70.00.0
China10.510.811.10.40.3
Total Non OECD45.646.747.81.11.1
Total91.492.994.21.51.3

Source: OPEC (million b/d)

This is also backed up by private sector forecasters such as Goldman Sachs:

Chart 3: 2016 Demand Forecasts - Goldman Sachs ('000 b/d)

Chart 3: 2016 Demand Forecasts - Goldman Sachs ('000 b/d)

Source: Goldman Sachs

On the supply side of the equation, Non OPEC supply rose in 2015, although about 300,000 b/d less than the increase in global demand. In 2016, however, the weakness of prices and the decline in investment should lead to a contraction in Non OPEC supply of 660,000 b/d. For instance, between its December and January reports, OPEC reduced its forecast for US production sharply, from a decline of 170,000 b/d to a decline of 370,000 b/d.

Non OPEC Oil SupplyChange
20142015201620152016
Americas20.0820.8720.430.79-0.44
(US)12.9613.8713.500.91-0.37
Europe3.603.733.670.13-0.06
Asia Pac0.510.470.45-0.04-0.02
Total OECD24.1925.0724.550.88-0.52
Other Asia2.602.692.720.090.03
LATAM5.015.185.220.170.04
ME1.341.261.23-0.08-0.03
Africa2.362.352.33-0.01-0.02
FSU13.5513.6313.460.08-0.17
Other Europe0.130.130.130.000.00
China4.294.374.370.080.00
Total Non OECD29.2829.6129.460.33-0.15
Processing gains2.162.192.20
Total55.6356.8756.211.21-0.66
OPEC Production36.7738.0038.60
Surplus/Deficit1.041.980.63

Source: OPEC (million b/d)

However, considering the decline in the US rig count relative to production (see chart below), this still could prove an overly optimistic forecast. Shale oil producers operate at a higher point on the production cost curve and despite the recent decline in oilfield services costs and efficiency gains driven by technological advancements, current crude oil prices make incremental investment uneconomic for many shale operators.

Another characteristic of shale wells is a higher depletion rate. When combining the higher depletion rate with the disincentive current prices provide for incremental investment, there should be a sharp decline in production by the end of 2016. Indeed, even before the further swoon in oil prices in December and January, US shale oil production declined by an average of nearly 90,000 b/d per month (and at an accelerating rate) in the six months to November, so, in our view, it is likely that OPEC's forecast for US production will soon be revised significantly lower.

Chart 4: US Shale Oil Production vs. Rig Count

Chart 4: US Shale Oil Production vs. Rig Count

Source: EIA

The removal of most sanctions against Iran will, of course, increase global oil supplies. Iran is currently producing about 2.8m b/d and has official capacity of 2.9m b/d. It is estimated, though, that Iran currently has 50m barrels of oil in storage (down from 70m a few months ago), which indicates that excess supplies have already impacted the market. Furthermore, the Iranians have stated that within a year they will be able to increase production back towards the 3.8m b/d that they were producing before sanctions were introduced.

The fear of this upcoming supply has already contributed to declining oil prices, but the US Energy Information Administration (EIA) disputes this estimate and believes that 600,000 b/d of additional production is more realistic at end 2016, as the country's old oil fields naturally deplete at a rapid rate and as the lack of regular maintenance has taken its toll.

Chart 5: Iran Oil Production ('000 b/d)

Chart 5: Iran Oil Production ('000 b/d)

Source: Bloomberg

Assuming, as we do, that OPEC ex-Iran production for 2016 is unchanged from 2015 and Iran adds an average of 600,000 b/d (assuming additional production ramps up towards 1m by year end), then, given stronger global demand, the oversupply of oil in the market would decline from the current 2m b/d to 600,000 b/d.

Moreover, if Iranian production increases are disappointing (as we believe is likely), the US production decline is larger than expected, or global demand growth actually trends above current expectations (as it did for 2015), the market could be even close to fully balanced by the end of the year. In our view, even if the market remains in slight surplus, it should be positive for crude oil prices from their currently depressed levels.

Recent U.S. Policy Changes

Despite the numerous headlines in the media, the recent end of the crude oil export ban in the U.S. is likely to have minimal near-term impact on the global balance. Given the costs associated with transporting crude oil from the U.S. to Europe and Asia, and that both benchmark grades of Brent and WTI currently are priced nearly equally, it seems unlikely that the removal of the ban will encourage U.S. supply growth or increase demand for U.S. crude oil. In fact, given the surplus in global supply and the minimal storage capacity outside the U.S., it seems likely the U.S. will remain a net importer of crude oil. Some potential impacts of the lifting of the ban are less seasonal volatility in Brent-WTI spreads and increased incentive to build pipeline infrastructure from the Midwest to the East and West coasts.

OPEC vs. the IEA

Given the data presented above it may seem quite strange to read recent headlines from the International Energy Agency which is quoted as saying that, "the oil market could drown in over supply." Presumably it is looking at very different data or has wildly different forecasts? The answer to that is no. In 2016 the IEA expect world oil demand to grow by 1.2m b/d to 95.7m b/d whilst they expect Non OPEC supply to drop by 0.6m b/d so it is also expecting a significant draw on OPEC supply.

Conclusion

US shale oil has certainly changed the global oil market forever and has introduced a new swing producer with potentially an ongoing decline in costs due to technological advances. But it is also clear that the Saudi strategy has started to work — energy capital investment has plummeted over the past year and many producers face dire circumstances if prices do not recover.

In sum, US production in 2016, in our view, will be lower than current forecasts. Meanwhile, the decline in global oil prices has led to robust demand growth (that could well exceed current projections), along with a supply correction that will very likely result in a significant increase in the demand for OPEC oil by year-end.

However, this is a somewhat slow process and in the short term, concerns about oversupply and tightening (or even full) storage capacity are likely to maintain some pressure on prices. Further into 2016, however, the market should tighten and by the second half of 2016, it is quite possible that markets will be looking ahead at a potential supply deficit in 2017 and marking prices substantially higher.

Shale production will, of course, step in to meet some of that deficit, but the shale industry has been hit hard by the drop in prices. Some companies have entered bankruptcy and with low levels of maintenance spending the expected life of equipment is said to be falling for many producers. Banks, damaged by the 2015 shock, will also be significantly more reluctant to lend to the sector. Any future production gains would, thus, keep some downward headwind on prices, but are unlikely to be so large as to stop prices from staging some recovery.