Back in September, with Brent crude oil prices sitting a little above $110, I predicted that Brent would drop to $100 or below by the end of November. While prices made an initial move in this direction, unrest in the Middle East and the weakening dollar (among other catalysts) have brought Brent crude back up to $110 at year-end. This demonstrates the danger of making short-range predictions based on long-term trends; other short-term factors can intercede and dictate the short-term price action.
However, the long-term trends that I identified in the earlier article are still present, and over the course of 2013, I expect growing supplies (and relatively stagnant demand) to pull Brent prices down below $100. The critical driver is the opening up of new transport capacity to move U.S. inland crude to the coasts in order to replace imported crude, which will in turn pressure Brent prices. This will allow the U.S., and the rest of the world by extension, to take advantage of rapidly growing domestic production that thus far has had trouble getting to market.
On Friday, the EIA released the last Weekly Petroleum Status Report of 2012, which highlighted how rapidly the U.S. oil supply is growing. For the week ended December 21, U.S. crude production totaled 6.984 million bpd (barrels per day), more than 1.1 million bpd above the comparable period last year. For the full year, production has averaged 6.22 million bpd, up nearly 600,000 bpd over last year. While some commentators have worried that the "shale boom" is peaking, production figures do not support that view. Growth rates have increased strongly through the year. However, higher production has only impacted the price of WTI, while Brent crude has remained above $100 for most of the year, due to insufficient takeaway capacity in the U.S. In fact, Cushing oil stocks reached a record high above 49 million barrels last week (up 19.3 million barrels year-over-year).
However, in 2013 we will see the completion of a variety of pipeline projects designed to move inland crude to the Gulf Coast. The most important by far is TransCanada's (TRP) Keystone-Gulf Coast Project, which is projected to start up in mid-late 2013. This pipeline will move up to 700,000 bpd from the Cushing oil hub to Gulf Coast refineries, which could replace nearly 10% of U.S. crude imports. In another important development, the Seaway pipeline, a joint venture between Enbridge (ENB) and Enterprise Energy Partners (EEP), will increase its capacity by 250,000 bpd next quarter. These two projects along with various smaller ones will bring as much as 1.5 million bpd of additional U.S. supply to Gulf Coast refineries by the end of 2013. Meanwhile, Berkshire Hathaway's (BRK.B) BNSF Railway recently announced that it has expanded its carrying capacity for Bakken crude to 1 million bpd. This will allow Bakken crude to move to the East Coast or the West Coast, where refineries currently rely upon seaborne crude tied to Brent prices.
As rising U.S. production combined with better crude transportation infrastructure allows refineries to replace imported crude with U.S. crude, demand for Brent crude will drop. This trend will be bolstered by weak U.S. demand for petroleum products, as a result of efficiency gains (for example, sales of new, smaller, more fuel efficient cars and trucks are rising rapidly) and continued economic weakness. (I do not believe that the likely effects of imminent U.S. tax increases/spending cuts on petroleum demand have been reflected in the market yet.)
Moreover, international demand is not growing fast enough to buoy Brent crude prices as U.S. demand for Brent sinks. The IEA is projecting world demand growth of 865,000 bpd in 2013, bringing world oil demand to 90.5 million bpd. However, production last month was already 91.6 million bpd, indicating that even with flat production next year, the market would be oversupplied. While OPEC, and primarily Saudi Arabia, can try to bolster prices by cutting production, I do not think Saudi Arabia is willing to cut production on the scale needed to keep prices above $100. Supply is on pace to outstrip demand by 2-3 million bpd in the seasonally weak Q2. To balance supply, Saudi Arabia would have to cut production by 20%-30%, which would wreak havoc on the kingdom's budget. By contrast, the Saudis might be able to hold the line at $90-$95 with minimal production cuts, as consumption could be at least 1% higher at that price level.
It should be noted that the "invisible hand" would not cut into production in a material way unless crude prices drop well below $90. U.S. shale oil producers have rapidly grown output even though WTI prices (which are the baseline for "inland" U.S. crude) have been below $90 for much of this year. The continuation of this rapid growth shows that exploration and extraction of non-conventional sources of crude is economic at well below the psychologically important $100/barrel level.
An implication of this analysis is that oil majors like Exxon Mobil (XOM) may not do well next year, due to falling oil prices and weak demand for petroleum products. Instead, the logistics companies highlighted above have better prospects. Regardless of where demand settles, logistics companies will benefit from the glut of inland U.S. crude, which is likely to remain, to some extent, for the next several years. Producers and refiners are willing to pay to get domestic crude to market, because the cost of production is well below Brent prices. With U.S. production increases showing no signs of slowing, logistics companies can look forward to continued growth over the next several years.