Underinvestment and Demand Growth Will Help Sliding Oil Prices Recover Footing
While U.S. producers have been able to ramp production at lower breakeven prices, underinvestment by non-OPEC producers outside the U.S. and steadily rising global demand lay the groundwork for a future upswing in prices.
After falling more than 6% in a week, oil prices pared their losses Friday, May 5, rebounding 1.6% as the “tug of war” between Organization of Petroleum Exporting Countries (OPEC) and U.S. shale producers grinds on. In a good analysis entitled “Oil Nearing Capitulation,” Goldman Sachs points out that oil’s retracement back to levels last seen toward the end of November, when the cartel struck its current output cut accord, is driven by two main factors: softening Chinese economic data, which is also taking a toll on metals prices, and “once again, the influence of technicals and positioning.”
Despite murmurs that OPEC at its May 25 conclave may extend its output pact into the second half of this year, surging U.S. shale output and still-high crude and especially U.S. gasoline inventories will doubtless continue to weigh on prices near term. But before too long, we believe, a dearth of non-OPEC investment outside the U.S., combined with natural reservoir decline rates and steadily rising global demand, should cause oil prices to stop slipping, stabilize for a year or so, and then enter into a cyclical upswing.
Goldman argues that the ability of U.S. shale producers to deliver better-than-expected production at roughly $50 per barrel has pressured market expectations for future oil prices or marginal supply breakeven costs. Yet we think the market is overestimating the ability of U.S. shale producers to deliver enough volume to offset international declines, which could be intensifying due to recent underinvestment in long-term projects with significant volume growth potential, such as offshore production. Global exploration and production capex declined an estimated 25% in 2016, modestly less than the 27% decline the year before. A managed decline rate typically runs about 3% to 5% for most portfolios. Without investment this could be higher in the near term. Can ramping U.S. shale compensate?
Goldman forecasts U.S. production will reach nearly 12 million barrels per day (b/d) by 2020, up about 3 million b/d from today’s level. But the demand side is also growing. The International Energy Agency forecasts global oil demand to reach 97.9 million b/d in 2017. Assuming the oil market is balanced after OPEC’s 1.2 million b/d cut, non-OPEC producers (excluding the U.S.) represent about 49 million b/d of production. If we assume a 3% decline on the 49 million b/d, the market would lose about 4.25 million b/d in production by 2020. That’s almost exactly the predicted volume growth from the U.S. plus a reversal of the OPEC cut. In this scenario global production would stay flat during a period in which world demand is likely to grow to 101 million b/d, assuming 1% growth per year. That implies a production shortfall of about 3 million b/d not far down the road.
Or sooner. Any delays in new projects or accelerated declines due to underinvestment could cause the market to be meaningfully undersupplied. For example, a 5% decline rate on non-OPEC, ex-U.S. production would imply an output loss of 7 million b/d by 2020, which would leave the 2020 deficit closer to 7 million b/d. The last two times we had a supply shortfall of more than 2 million b/d was in late 2007 and 2011. Both times oil exceeded $100 per barrel.
Over the next one to two years, we might see crude prices trading range bound as U.S. shale maintains the supply and demand balance. But at some point that balance will break as the non-OPEC, ex-U.S. declines become more apparent.