Something has to give in the oil market

As investors move on from concerns around oil supply constraints following the recent Saudi oil attacks, oil market commentators are forecasting a large supply-demand imbalance in the other direction in 2020 with supply growth from the US, Brazil and Norway not expected to be absorbed by new demand. Estimates of the surplus vary, but it is clear that it is large – the narrowest forecast is 0.6 million barrels per day (mnb/d) and the widest is 1.2mnb/d (equivalent to 0.6-1.2% of global consumption).

This is a continuation of the dynamic of the past five years; supply growth has tended to exceed demand growth either leading to inventories building (and the oil price crashing), or provoking OPEC to cut production and cede market share.

The reason the current situation is significant is that the imbalance implied by current forecasts is up to 3x larger than the five-year average.

2020 supply growth is roughly, evenly attributable to US shale, and mega-projects in Brazil, Norway and Russia, which are longer-cycle and hard to slow down.

Such a surplus is comparable to that of 2014, which marked the beginning of the ‘new era’ of lower oil prices. Importantly, 2014 also saw a temporary disintegration of OPEC, exacerbating the oil price fall of 2015/16.

Based on the current supply-demand outlook, it is very hard to imagine the oil price rising in 2020. Yet, that is exactly what is expected. The range of broker estimates for 2020 average Brent oil prices is $55-$81/barrel, with most clustered around $60-$65/barrel.

The current earnings forecasts for the oil majors by European brokers assume Brent crude at c. $60-$65/barrel. This suggests there is downside risk both to oil price expectations and earnings forecasts for 2020.

With the ‘driving season’ in the Northern Hemisphere now behind us, demand will seasonally fall. As we approach 2020, global inventories will begin to build, and this supply-demand imbalance will become increasingly visible.

How is the changing landscape impacting the oil price?

The real trouble for the oil price began in late 2014, when US inventories began to break out of their long-term average range. The trend continued into 2015 as inventories went on to set new highs. The oil price fell throughout 2015, and was ultimately forced to go to a ‘supply limiting’ level of c. $27/barrel at the beginning of 2016.

At this price level, some oil fields could not cover their operating costs and were, therefore, forced to shut production, helping to balance supply and demand – a dynamic also seen in early 2009.

The US rig count fell sharply throughout 2015-16 eventually leading to production decline in the US and inventory stabilisation This was enough for the oil price to begin recovering in early 2016, helped further by OPEC reforming later in the year.

Fast forward to today – while the statistics are noisy, global inventories are building up again, and we expect to see sustained evidence of over-supply in the coming months.

All else being equal, US inventories will breach their long-term average range within 2-3 months, once the 2020 supply-demand balance is established. It is difficult to judge exactly when this will be but it seems likely within the next 6-9 months as seasonal demand weakens and US production is still influenced by a relatively high rig count. This will very likely be paired with lower spot oil prices.

There are two main ways in which this demand/supply imbalance can be resolved:

1.Deeper OPEC cuts

In its 60-year history, OPEC has generally been successful in rebalancing the oil market through production quotas. The oil price crash which began in 2014, troughing in early 2016, was exacerbated by the failure of OPEC to reach an accord on production controls. Saudi Arabia instead aimed to push US shale out of the market by competing for production. This strategy was abruptly reversed in late 2016 when OPEC returned with a production quota which included an accord with Russia (called ‘OPEC+’).

2018 saw the agreed cuts being reversed, but this was a direct result of the US decision to introduce economic sanctions on Iran. Confusingly, although the sanctions were implemented as planned, waivers were also granted to certain consumers of Iranian crude. This left the market long crude as Saudi Arabia had carefully increased production to absorb the lost Iranian barrels. It was this, rather than fears of weaker economic growth, that was the biggest driver of the oil price falling from $85/barrel to $55/barrel in the fourth quarter of 2018. OPEC then initiated another round of cuts, which are still in place today.

Importantly, it is Saudi Arabia that is ensuring the cuts are deep enough, by over-complying with its allocation by c. 200%. Effectively, we can view the next step by OPEC+ as the behaviour and intentions of Saudi Arabia.

The main focus of the next OPEC meeting, which will take place on 5-6 December, was to be whether or not to sustain the current cuts beyond the agreement of February 2020. There is no doubt this is necessary and early comments from OPEC members indicate deeper cuts are also being considered.

Further cuts are a big decision for Saudi Arabia as it would take oil exports down to levels (in absolute terms) not seen since the 1990s. The lost revenue would be equivalent to c. US$20 billion, or 3.2% of Saudi Arabia’s GDP (all else being equal).

However, an oil price fall of $10/barrel for a full year would have this effect anyway. As a consequence, the decision to initiate further cuts should be relatively straightforward, as inaction would likely drive the oil price down by more than $10/barrel.

The most likely outcome is that OPEC+, shouldered by Saudi Arabia, will introduce further production cuts to rebalance the market. Based on recent history though, the discussion ahead of the decision is likely to be difficult and noisy.

There are two reasons why decisive action on further cuts is not guaranteed at the forthcoming OPEC meeting; firstly, it is probable that the market will not be ‘obviously imbalanced’ in December, and secondly, in the past, OPEC has tended to take a ‘wait and see’ approach to implementing cuts.

So while an OPEC+ production cut is needed to avert oil market oversupply in 2020, a cut will likely only be made once the market is clearly oversupplied.

Further supply disruptions through conflict in the Middle East are an upside risk to the oil price, and have risen in likelihood over the past few weeks, but the resilience of Saudi oil production following the recent attack has surprised everyone, and the most recent indications are that a diplomatic solution will be pursued in Yemen. The fact remains, though, that supply disruption of this kind is not forecastable.

2.Curtailing non-OPEC supply

US shale has accounted for two-thirds of global oil supply growth over the past five years. Shale production is sourced from thousands of individual wells, rather than large-scale, multi-year projects. This leads to the (false) conclusion that shale is ‘short-cycle’ and can be turned on and off easily, making the oil price less volatile.

However, if we look at the period from mid-2014 to mid-2015 (when the oil price crashed), the US rig count fell by more than 50% while US oil production continued to grow by 1.1mnb/d (12%). The reasons for this were that more wells were completed than drilled, and the wells that were completed were highly productive (high-grading). The US rig count ultimately fell 80% peak-to-trough over the course of two years between 2014 and 2016, with US oil production only rolling over very slowly.

This asymmetric relationship between oil price movements and US shale production – where production grows rapidly when the oil price is high or rising (dampening price rises) but continues to grow for a period in a downturn (even with a sharp fall in the rig count) – means that it is very difficult for lower shale activity and falling rig counts to correct near-term oversupply in the oil market…but they can correct undersupply.

We are seeing a repeat of this dynamic in 2019. The US rig count is -20% since the start of the year, but US oil production has grown by 7%. We expect the US rig count to continue to decline, but the pace of this reduction is unlikely to halt US oil production growth in the coming months.

Where to from here?

The combination of ‘difficult to halt’ long-cycle projects coming onstream in 2020, US shale continuing to grow given the lag in rig count decline, and global demand likely coming in at the lower end of the recent range, means we are set to go through a period of crude inventory builds which have, historically, been negative for the oil price.

The establishment of OPEC+ at the end of 2016 has allowed for oil price manipulation and, ultimately, I believe that the cartel will do what is necessary to support the price. However, based on recent history, I am not convinced it will act swiftly enough to avoid the oil price weakening; particularly given that we are now in the seasonal low period for demand.

As a result, the most likely outcome is that further action will be required in the first half of 2020 –probably provoked by a lower oil price.

What are some of the risks to this view?

  • US supply could roll over more quickly than expected; most likely as a result of the rig count being cut very hard towards the end of 2020. 
  • Demand could surprise to the upside
  • Unexpected supply disruptions such as hurricanes, oil spills, facility failures and geopolitical conflicts can have a sizeable impact, as we recently learned. Yet, we’ve also learned that these need to be ‘prolonged’ events to concern oil markets.
  • OPEC+ could produce a ‘bazooka’ supply cut. This may increase in likelihood given the impending IPO of Saudi Aramco.

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