In January, two of our senior portfolio managers, Daniel Forgie and Simon Down discussed the outlook for global oil markets and the improving fundamental picture for supply and demand.
Since the middle of February, crude oil prices have witnessed a dramatic recovery and energy stocks have followed suit. Our portfolio managers now reassess their view after the rally and examine how the fundamental picture has evolved over the year so far.
Reviewing the Supply / Demand Balance
In the past few months, there has been some incremental improvement in the fundamentals, but the world remains oversupplied by 1-2 million barrels per day (b/d). U.S. production has begun to decline and is now nearly 500,000 b/d below the peak levels of last year, after the dramatic reductions in capital spending since the beginning of 2015. OPEC and the International Energy Agency (IEA) both indicated in their most recent monthly reports that they expect demand to grow this year by about 1.2m b/d. This, combined with expected declines in non-OPEC production of approximately 700,000 b/d, should bring the crude oil market into a healthier balance by year-end. Meanwhile, the U.S. Energy Information Administration (EIA) currently forecasts the market moving back into deficit by Q3 2017, bringing an end to the period of oversupply which began in Q1 2015.
Crude Oil Demand & Supply, including forecasts
In the short term, prices may have overreacted, as the market remains oversupplied, but at least part of the recent rally is reflecting the fact that by this time next year, the fundamentals of the crude oil market are expected to be healthier. There are two reasons for this change in fundamentals – firstly, demand growth should remain solid, driven mainly by emerging markets and most importantly by China. Secondly, there is less likelihood the market will witness a repeat of the growth in production activity that occurred over the past five or so years, due to tighter credit conditions and the high cost of production for many non-OPEC producers.
Indeed, much of the Non-OPEC excess production capacity is not economically viable at current prices, thereby limiting the availability of new supply. Despite the recent significant drop in production costs (due in part to the pressure put on oilfield services pricing), marginal production costs in some shale basins in the U.S. remain above current spot crude oil prices. Marginal costs for deep water and oil sands production are also above current price levels on average.
Commentary from companies like Pioneer Natural Resources have indicated that they might increase their rig count at price levels above $50 per barrel, but this company is one of the best-of-breed operators and is drilling in the low-cost sweet spot of the Permian Basin in Texas. It is unlikely we will see industry-wide increases in production activity until there is more confidence in the sustainability of the price recovery and forecasts for Non-OPEC supply continue to trend downwards. For example, when we wrote our piece in January, OPEC was expecting Non-OPEC supply to decline by 660,000 b/d in 2016, but now it has increased this expectation to a decline of 730,000 b/d.
Iran continues to add supply to the market, which could offset the declines in U.S. production. According to the most recent OPEC monthly report, Iran has increased production by over 400,000 b/d since the end of 2015 and this trend seems likely to continue. According to a recent Bloomberg survey of companies, producers, and analysts, OPEC increased output in April by the most since 1989, at over 484,000 b/d. Iraq also has increased production over the past year and Saudi Arabia maintains some excess production capacity, as well.
The recent price recovery will likely incentivize low-cost producers to increase supply, thereby capping the upside potential for prices. In addition, there have been various supply disruptions over the past several months that have contributed to the improvement in fundamentals. If those situations stabilize and the facilities return to optimal production, it would also be a headwind for prices. Of course, any deterioration in the demand outlook would also be a negative development.
Most observers expect global demand to grow by over 1m b/d in 2016 with OPEC expecting demand to grow by 1.2m b/d. This is obviously important to improving the market balance and if the global economy weakens in the second half, such could delay further price recovery. Another issue is inventories. The U.S. data shows crude oil inventories at extremely high levels on a historical basis and these are unlikely to completely normalize for a considerable time.
Department of Energy: U.S. Crude Oil Inventories (million barrels) vs. Long Term Average
Continued growth in demand from China is critical to an improvement in oil market fundamentals. The country is expected to account for over 300,000 b/d of incremental demand this year. The source of demand is both from an increase in automobile demand in China as well as the effort to build the country’s strategic petroleum reserves (SPR). According to recent reports, in 2016 there are four new SPR sites expected to come online, adding a total 98 million barrels (mb) of capacity and for sites that are currently under construction, developers are facing pressure to finish quickly, as the government wants to fill those tanks in the current low price environment. In total, 228mb of capacity is planned for Phase III of the country’s build out of its SPR. Were this total capacity to be built and filled between 2017 and 2020, it would imply 156,000 b/d of demand over that period.
Finished and under construction SPR sites in China (million barrels)
Source: Argus, Reuters, Barclays Research
Saudi policy and the potential for the U.S. to assume the role as “swing producer”
The pivot in Saudi policy has been fascinating to observe. At first, many doubted the kingdom’s determination to abandon its role as the “swing producer”, whereby it has historically managed the global oil price by adjusting its own production levels. Now, it clearly is protecting its market share and using its position as a low cost producer to do so. As part of this strategy, Saudi Arabia has sought to damage higher cost producers (mainly U.S. shale producers) in order to discourage continued supply additions from those sources. One shouldn’t underestimate its continued commitment to this strategy. That makes the prospect of a significant action at OPEC’s next meeting in June less likely in our opinion. That being said, the market balance can still improve even without an OPEC supply cut.
The advancements in the U.S. energy industry over the last decade have been astounding, not only from the standpoint of how increased production has affected the global crude oil market, but also in the geological, engineering, and technological breakthroughs that make accessing natural resources more efficient and less costly. Some believe these advancements have positioned the U.S. as the “swing producer” for the global oil market. One example of these technological breakthroughs comes from the largest onshore U.S. producer in the lower 48 states – EOG Resources (EOG). It highlights the improvement in drilling efficiencies that many of the companies have been able to achieve. According to EOG, it can identify the "sweet spot" in a given drilling location and once it has been identified, the company can then steer its drills into a 20-foot horizontal window over a mile underground. This enables EOG to place its lateral wells exactly on target, which is crucially important in efficient shale oil production.
In addition to drilling technology, 3D seismic analysis, longer-lateral lengths, the usage of more fracking proppant, and better logistics management have all contributed to greater well efficiency. The question of the ability of the U.S. to assume the role of “swing producer” is an interesting one in that the U.S. won’t be able to fill that role in the same way that Saudi Arabia traditionally has. This is a function of the fact that Saudi Arabia has a state-owned oil company with a cost of production in the single digits, and the U.S. has a fragmented group of producers, none of whom really produce enough to move the overall market, and all of whom have a much higher production cost. In the past, U.S. shale producers had been able to access capital markets to fund production growth, without regard to cost or project returns – but now those days are largely over and this will limit their ability to quickly ramp up production.
Monthly U.S. Shale Oil Production Change b/d
Source: EIA (April 2016 – June 2016 estimated)
Based on data from the Joint Organziations Data Initiative, an initiative by organizations including OPEC and the IEA to improve data transparency in oil markets, a basic analysis shows that simply looking at the production level increase from Saudi Arabia ignores the impact that local demand growth has on the desire for additional supply. Further investigation shows that Saudi could in fact be drawing down its own inventories (while other producing countries have seen theirs spike) in an effort to maintain their market share in global supply. This calls into question the sustainability of this effort, and may indicate that global oil markets are actually tighter than they may appear.
As Saudi Arabia heads into peak demand season due to the use of oil for electricity generation to power air conditioning throughout the country, domestic demand is only set to increase, leading the kingdom to a choice between a further draw-down of inventories, attempting to increase production which is already elevated and perhaps close to realistic capacity, or ceding global market share.
Saudi Arabia: Production, Demand and Inventories
Joint Organisations Data Initiative
Production Disruptions Re-emerge as a Risk
One need only look at some of the recent events to understand the importance of geopolitical risk. With all the focus in the global oil market on U.S. shale production and weekly inventory level updates, incidents of supply disruption have been largely ignored throughout the oil price downturn. Recently however, several high-profile events have grabbed the market’s attention and given pause to the notion that oil markets will remain oversupplied in perpetuity.
According to the EIA, global supply outages recently reached 3.93m b/d, the highest they have recorded since 2011. Some of these, such as Libya, were expected given the domestic political situation that is keeping production well below potential, but others are new, short or medium-term problems with a good deal of uncertainty regarding their ultimate outcome.
Estimated May 2016 Production Outages (EIA)
|Libya||High||1.4m b/d||In Libya, a power struggle between the U.N.-backed unity government and Eastern groups who believe that they should be in control of the country have resulted in an export blockade which has seen oil exports slump. Oil exports were 400,000 b/d in 2015 and could be 300,000 b/d or even lower in 2016 unless the current conflict is resolved. At full capacity, Libya was previously producing around 1.6m b/d, so a huge part of the country’s operations are stalled. Markets already factor much of this in, but the fact that production can’t even be sustained at such a small fraction of full capacity is a further disappointment.|
|Canada||Low||1m b/d||Canada’s wildfires have now burned 161,000 hectares and forced the evacuation of close to 100,000 people, shutting down some Canadian oil operations, as employees have had to be evacuated. At the worst point, the fires halted approximately 1m b/d of production and Goldman Sachs estimates that if companies can restart production reasonably quickly then the loss will average 650,000 b/d over a three week period.|
|Nigeria||High||0.7m b/d||Infrastructure attacks are now growing once again in Nigeria with attacks at Chevrons Okan offshore facility as well as the Forcados and Brass River operations and the Trans Forcados pipeline. These disruptions are a result of Niger Delta residents who are demanding a larger share of oil revenues after new President Buhari ended pipeline protection contracts agreed under the previous government. The pressure on the government’s fiscal budget could make preventing future attacks like this more difficult than in the past.|
|Saudi Arabia||Medium||0.25m b/d||Kuwait and Saudi have two oil fields in the Neutral Zone between the two countries. Wafra has capacity of 200,000 b/d and Khafji has capacity of 300,000 b/d. Khafji was shut down in October 2014 whilst Wafra was shut down in May 2015. The two countries are in dispute about the renewal of operating licenses but have now agreed to restart production in ‘small quantities’. Full production is expected to resume, but not until 2017.|
|Kuwait||Medium||0.25m b/d||The Kuwait outages relate as above to the Wafra and Khafji fields. Kuwait has also been hit with strikes in April, with oil production down by 1.1m b/d for one weekend. The strike was in protest at pay cuts and plans to privatize parts of the energy sector. Although workers have now returned to work, 1,200 contract workers went on strike again at the start of May over unpaid allowances.|
|Venezuela||High||0.178m b/d||Large oilfield services companies like Schlumberger and Halliburton announced they are curtailing their activities in Venezuela, after the state-owned oil company, PDVSA, struggled to pay its bills. The country is looking ever more on the verge of breakdown with President Maduro cutting the working week for public servants to just two days in order to save electricity. Oil production in Q1 2016 averaged 2.59m b/d vs. the 2.78m b/d average in 2015. Energy Consultancy IPD Latin America, in a recent report, believes that oil production in 2016 could average just 2.35m b/d, downgrading their forecast from 2.62m b/d unless oil prices rise towards $70-80. In other signs of strain in the industry, the country is re-routing gas from well-pressurization towards power generation and delaying well maintenance.|
|Iraq||Low||0.15m b/d||In late February, the Kurdistan Workers’ Party (PKK) was blamed for an attack on a pipeline which delivers approximately 600,000 b/d from northern Iraq to Turkey. This is not the first time this pipeline has been attacked, as a similar disruption occurred last year. Baghdad is now holding back around 150,000 b/d from being exported through Kirkuk in order to starve the Kurds of revenue. The conflict with ISIS is also taking a toll, although so far, outages from attacks have been relatively small.|
For some of these events, such as the Saudi/Kuwait issues, they are long-term in nature but also have a clearer path to resolution. Iraq is also likely to be resolved; either as the government comes to some agreement with the Kurds after sufficient pressure or simply redirects the oil for export via another route. Canada’s disruption should be confined to the first half of the year as the wildfires are now contained and oil production is starting to come back online (although smoke is slowing the restart).
The situations in Libya, Nigeria, and Venezuela are less predictable though and these three markets are likely to continue to put a drag on supply through 2016. This has the potential to reduce supply by up to 1m b/d of production, which will have to be made up by other producers.
After updating our outlook, we are left even more convinced of the conclusions we made in January. We continue to believe that the medium term fundamentals are improving and that the rally in oil prices is a combination of unexpected production disruptions and markets looking through current oversupply to the much stronger backdrop that should be in place in 2017. The rise in prices is, thus, quite rational and barring a dramatic and unexpected decline in demand, the worst point for oil prices now appears to be behind us.
Given the balance of factors, prices for 2016 should meet some resistance at $65, in our view, unless there is an unexpected, severe supply disruption or a new major geopolitical risk develops. Meanwhile, the risk of a price-correction has not disappeared, but such a correction should not be a surprising within the context of a longer-term rally. We would view any such correction, thus, as a buying opportunity for the likely continued improvement in 2017.