“The problem with oil is that there is always too much or too little,” the American economist Myron Watkins famously wrote in 1937, in his seminal paper on the oil market, “Oil: Stabilization or Conservation?”
Demand for oil has been growing steadily since crude prices started their precipitous decline in 2014.
Markets have proven this truism over and over ever since. Recently, investors seem to be reacting once again to fears of “too much” oil in the market, triggered this time by a surprise build in U.S. inventories, combined with comments from Saudi Arabia’s oil minister that OPEC may not extend its current production deal. As a result, the price of benchmark West Texas Intermediate (WTI) crude fell by $3-$4 a barrel, to below $50 a barrel—again.
And once again, people are asking: Is the oil market recovery over? Despite these short-term jitters, we believe that the medium-term outlook remains constructive. After all, even amid rising renewable energy and electric vehicle sales, demand for oil has been growing steadily since crude prices started their precipitous decline in 2014—a trend that shows little sign of slowing. Meanwhile, OPEC has successfully constrained the supply side of the market by lowering output targets. Drilling activity in U.S. shale oil is picking up rapidly, but not fast enough to prevent a period of sizeable inventory draws late this year.
U.S. Shale Production
For oil inventories to drop again, the price of the futures contract will likely have to trade below the expected level at maturity, something market pundits refer to as “backwardation.” With the long end well underpinned by marginal cost arguments, short-dated oil futures will need to move higher—we think into the low $60s—toward year-end.
At that point, we believe that OPEC discipline will probably start to wane, and U.S. shale oil production will accelerate. We estimate that U.S. shale may return to growth of around a million barrels a day sometime between the fourth quarter, 2017, and fourth quarter, 2018.
Still, with demand growing at, or slightly above, the historical trend rate and declines in supply from several non-U.S./non-OPEC countries, the market looks broadly balanced over the next year. Some might argue that U.S. supply growth meeting the vast majority of global demand growth is problematic. However, it’s worth highlighting that this has been the case for extended periods in the past: Between 2005 and 2015, the U.S. met 76% of all demand growth.
With a broadly balanced market, prices should remain stable in the low $60s throughout 2018. What about the long term? Will demand-peak and technology improvements keep the cost of oil at, or even below, current levels? Perhaps, but we are somewhat skeptical. The world is adding a billion people every 14-15 years, during which global per-capita GDP typically rises by 35%-40%. Historically, improvements in energy efficiency alone have been unable to offset this growth in demand.
Pricing Incentives
To illustrate: The global car fleet increases by around 40 million units a year, even after accounting for scrapped vehicles. Around 1% of new vehicles is electric. That means that, even if the rest of the new fleet drove 9,000 miles per year, at 40 miles per gallon, oil demand would grow by 0.6 million barrels a day every year. That would already account for half the 10-year trend rate, before taking into account the impact of growing fleets of trucks, planes, ships and rising demand from the petrochemical sector.
Oil is a mature energy source and efficiency is improving, but “peak demand” is still some time off. By 2020, we estimate that some 1.5 million barrels a day of additional production will need to come from as-yet-to-be-approved projects, with break-even oil prices of $70-$75 per barrel. A range of factors could push this number up or down, but this remains our best estimate. By 2025, the reliance on this category of projects could rise to seven million to eight million barrels a day.
This means that, at around the turn of the decade, oil prices must rise to a level high enough to make it worthwhile for producers to develop these reserves. New regulations for bunker fuel, which take effect in 2020, will put a premium on low-sulphur crudes, such as Brent, adding extra incentive.
How can investors position for this scenario? Our equity strategists are overweight the energy sector in Europe, which has lagged year-to-date, trades at a discount to the U.S. energy sector, and has a positive cost-reduction story. Meanwhile, in the U.S., we think that the oil services sector, more than the exploration and production section, is best placed for a pickup in U.S. production.
Adapted from a recent edition of Morgan Stanley Research’s “Sunday Start” (Mar 12, 2017) series. Ask your Morgan Stanley representative or Financial Advisor for the latest coverage and reports on the outlook for oil and the energy sector. Plus, more Ideas.
