Oil Price Shifts Into Overdrive
Supply and demand dynamics, along with political fuel injection, may keep crude prices running hot.
“The cure for high prices is high prices.” So goes the old saw in commodities. Oil is having a banner year, but it’s unlikely higher prices will spur sufficient investment and production to boost supply and lower prices anytime soon. Crude was up about 20% mid-way into 2018, and the energy sector was the best performer in the second quarter, in both the U.S. and globally, beating tech for the top spot. Near-term and longer-term drivers appear poised to keep oil prices strong.
Energy is generally a cyclical business. Crude prices are mostly tethered to supply and demand dynamics, with at least demand being largely affected by economic growth. But political risk also factors in and tilts the current equation rather heavily toward a supportive price backdrop. So energy stocks could have more room to run.
“Hope OPEC will increase output substantially. Need to keep prices down!,” U.S. President Donald Trump tweeted amid the Organization of Petroleum Exporting Countries June conclave. As commercial stocks in advanced economies have fallen below the key five-year average, OPEC pledged to ramp production in a bid to stabilize inventories, not necessarily to cool prices. But OPEC’s ramp, which Russia has vowed to join, isn’t all it appears to be because OPEC hadn’t been fully meeting its quota to begin with. Ramping output takes time, and the group’s capacity, even with Russia, is far from clear. Moreover, just days after OPEC’s announcement, Trump’s State Department ordered oil companies to cease purchases from Iran, OPEC’s third-largest producer. OPEC can’t raise output “substantially” and “keep prices down” without Iran’s 3.8 million barrels per day of crude.
As Total’s chief executive, Patrick Pouyanne told CNBC, international oil companies can’t work “in any country” hit by U.S. sanctions without a waiver because they could then be cut off from the U.S. financial system and be forced to abandon their operations in the world’s largest economy. It doesn’t appear that waivers will be forthcoming, and oil majors have been given until November to comply.
Meanwhile, the U.S. Energy Information Administration (EIA) recently reported that the world’s top 83 publicly traded oil and natural gas producers added a net 8.2 billion barrels of oil equivalent (BOE) to their proved reserves last year, raising the total 3.1% to 277 billion BOE. But oil companies are still struggling to stay on the treadmill as they face demand growth of about 1% per year and their existing fields have natural production decline rates of 3% to 5% annually. The companies’ collective budgets for exploration and production rose to $285 billion in 2017, but this is only slightly more than half of the 2012-2014 average.
That said, they have become far more efficient, reducing exploration and production costs and bringing the weighted average capex per additional BOE-to-proved reserves to $16, about half the roughly $32/BOE level in 2014. Indeed, as Thornburg Portfolio Manager Ben Kirby, CFA points out, many major oil companies had more free cash flow a year ago, when oil was bobbing around $50/bbl, than they did when it was fetching $100/bbl before mid-2014.
In addition to greater efficiency, energy industry capital expenditures increased 16% in the first quarter of this year from the year-earlier period, according to the EIA, suggesting more net organic proved reserve additions in 2018. Will it be enough?
It’s doubtful, especially with Iranian crude exports declining, the implosion of Venezuela’s oil production capacity, and current production or export disruptions in Libya, Nigeria and recently, Canada. Moreover, U.S. Permian crude output is facing pipeline scarcity that is limiting its production growth. Pioneer Natural Resources Chairman Scott Sheffield told Bloomberg during the OPEC meeting in Vienna that relieving capacity constraints could take up to a year.
If the supply side looks challenged, the demand side also paints a supportive picture for prices. Global oil demand is on track to break 100 million barrels/day (b/d) by the end of 2018. But that’s just in the months ahead. Long-term, the International Energy Agency (IEA) expects global energy demand to increase 30% between 2016 and 2040, given a forecast annual average 3.4% global economic growth rate and an increase in the world’s population to around 9 billion from 7.4 billion today. And urbanization will add “a city the size of Shanghai to the world’s urban population every four months,” further underpinning the IEA’s projections.
What’s that mean for oil? The IEA expects global oil demand to continue growing through 2040, “albeit at a steadily decreasing pace,” as natural gas and renewables usage increase sharply with growing emphasis on clean energy. But demand for oil is still expected to remain robust until the mid-2020s, and only slowly moderate thereafter as energy efficiency and fuel-switching accelerate for passenger car and electricity generation, according to the IEA. Yet oil demand for industrial use, road freight (trucks), aviation and shipping will remain robust. Even after displacement from natural gas, electric vehicles, and other alternative energy, the IEA expects global oil demand of 105 million b/d in 2040.
Two decades is a long time for most investors. But if long-term price support is coupled with current price drivers, depending on how much near-term upside is already priced into individual energy equities, some may still have considerable gas in the tank.