Oil - A tectonic shift
and the unintended consequences
Attempting to understand how the oil market will look during the next five years is a task of enormous complexity. Some certainties that have guided the market for decades are now not so certain: that oil prices falling to twelve-year lows will lead to a strong demand growth spurt; that oil prices falling to twelve-year lows will lead to a mass shut-in of so-called high cost oil production; and not least, that oil prices falling to twelve-year lows will force the largest group of producing countries to cut output to stabilize oil prices.
For some time now, analysts have tried to understand when the oil market will return to balance. A year ago it was widely believed that this would happen by the end of 2016 but that view has proved to be very wide of the mark. In 2015 and again in 2016 supply exceeded demand by massive margins, 0.9 mb/d and 2 mb/d respectively, and for this year we expect a further build of 1.1 mb/d.
Only in 2018 will we finally see oil supply and demand aligned but the enormous stocks being accumulated will act as a dampener on the pace of recovery in oil prices when the market, having balanced, then starts to draw down those stocks. Unless we see an even larger than expected fall in non-OPEC oil production in the second half of this year and/or a major demand growth spurt it is hard to see oil prices recovering significantly in the short term from the low levels prevailing.
It is very tempting, but also very dangerous, to declare that we are in a new era of lower oil prices. But at the risk of tempting fate, we must say that today’s oil market conditions do not suggest that prices can recover sharply in the immediate future – unless, of course, there is a major geopolitical event. Further, it is becoming even more obvious that the prevailing wisdom of just a few years ago that “peak oil supply” would cause oil prices to rise relentlessly as output struggled to keep pace with ever-rising demand was wrong.
Today we are seeing not just an abundance of resources in the ground but also tremendous technical innovation that enables companies to bring oil to the market. Added to this is a remorseless downward pressure on costs and, although we are currently seeing major cutbacks in oil investments, there is no doubt that many projects currently on hold will be reevaluated and will see the light of day at lower costs than were thought possible just a few years ago. The world of peak oil supply has been turned on its head, due to structural changes in the economies of key developing countries and major efforts to improve energy efficiency everywhere.
In the meantime, the forecast for oil demand to 2021 is for annual average growth of 1.2 mb/d (1.2%) which represents a very solid outlook in historical terms. Oil demand breaks through the 100 mb/d barrier at some point in 2019 or 2020. A major change from the 2016 MTOMR is the higher base from which our forecast begins. In 2015 world oil demand increased by 1.6 mb/d (1.7%), one of the biggest increases in recent years stimulated to a large extent by the rapid fall in oil prices that began in the second half of 2014 and gained momentum in 2015.
However, any expectations that the most recent fall in oil prices to USD 30/bbl oil will provide further stimulus to oil demand in the early years of our forecast and send annual rates of growth above 1.2 mb/d are likely to be dashed. In the first part of this year, we have seen major turmoil in financial markets and clear signs that almost any economy you care to look at could see its GDP growth prospects downgraded.
Here is what we see:
Since 2014 the non-OECD countries have used more oil than OECD countries and the gap will widen years to come. However, the rate of demand growth in the non-OECD countries is vulnerable to being pared back as the cost of energy subsidies becomes a major burden and governments take action which will have a significant impact on growth.
The continued rise in the global trade of oil will reach a peak at 37 mb/d in 2017 with the long-term eastwards drift continuing. Crude oil will be processed through refineries in ever rising volumes, although one of the most noticeable trends in the refining sector in the forecast period will be overcapacity in Asia.
As oil prices cascaded down from more than USD 100/bbl it was widely predicted at various milestones that the extraordinary growth in total US crude oil production from 5 mb/d in 2008 to 9.4 mb/d in 2015 would grind to a halt and move rapidly into reverse. Growth certainly ceased in mid-2015 but the intervening period has seen a relatively modest pull-back and total US crude oil production in early February 2016 was still close to 9.0 mb/d, aided by expanding production in the Gulf of Mexico.
There is a determination from members of the Organization of Petroleum Exporting Countries to maintain and expand their market share on top of rising oil production notably from Iraq, Iran, Saudi Arabia and Russia.
The impact on investment is noteworthy too: significant investment is required just to maintain existing production before we move on to provide the new capacity needed to meet rising oil demand. The risk of a sharp oil price rise towards the later part of our forecast, arising from insufficient investment is as potentially destabilizing as the sharp oil price fall has proved to be.
We are now living in perhaps the first truly free oil market we have seen since the pioneering days of the industry. In today’s oil world, anybody who can produce oil sells as much as possible for whatever price can be achieved. Just a few years ago such a free-for-all would have been unimaginable but today it is the reality and we must get used to it, unless the producers build on the recent announcement and change their output maximization strategy. The long-term consequences of this new era are still not fully understood and, as we enter a new chapter in history, it is important we do so understanding the global implications of readjustment to this new reality.
About the author(s)
Harold Alby is a managing director and chief operating officer at Inova Capital. Justin Inniss is a managing director at Inova Capital.For more details on our insights please get in touch with us at Inova Capital AG on +41 415616905. Inquire about our ideas and nowcasting capabilities.