The recent report from the International Energy Agency not only reinforced the strong probability the price of oil will remained subdued, but will be so for longer than expected.
I don't disagree with that, but I am more skeptical of its longer term outlook on rebalancing of the market. As a matter of fact, it wasn't even mentioned, and hasn't been mentioned by many analysts at all concerning how it will have an impact on the price of oil over the next several years. What I'm referring to is the inevitable recession in the U.S. that is coming.
Floated about over the last year or so has been the nonsensical idea the U.S. economy has somehow mystically decoupled from the global economy. That is after the rise of China and other emerging nations was proffered for years as the catalyst for the growth of the global and U.S. economies. Now that China and emerging market growth is slowing down, it is being presented something that is not going to have an impact on the U.S. economy. That's crazy.
Why this is so important to the price of oil is it isn't being priced into the supply and demand equation, and that will result in many investors being surprised at the changing oil scenario once the U.S. economy falters. It's a matter of when, not if it happens.
Since I believe it will be during the period of time the IEA has made these estimates, they have to be taken with a large grain of salt.
IEA oil outlook
Before getting into the projections from the IEA, it should be understood there is self-interest in any outlook from the 29 major oil importers comprising the organization. It also has been over-optimistic for a rebound in the price of oil in the recent past, saying there would be a ""relatively swift" recovery.
My view is they were operating under the assumption these were simply another supply cycle, rather than a disruption from the U.S. shale industry in the short term, and further out, a disruption from the global shale industry once deposits are further explored and brought into production, such as is happening in Argentina.
The organization admits the volatility in the current market make it "more difficult than ever" to make accurate projections, pointing to how badly it missed on its prior market and price rebound estimates.
As for the outlook from the IEA, it says it sees output through 2021 climbing by 4.1 million barrels per day. That's much lower than the pace of growth in supply in the last six years ended in 2015, which saw an increase of 11 million barrels per day.
Further out it sees U.S. oil output jumping to 14.2 million barrels per day by 2021, between 4 million and 5 million barrels more per day than today's level. With a general consensus being U.S. production falling as much as 600,000 barrels per day for 2016, it means if oil does rebalance some in 2017, it would put a lot of oil into the global market over the next several years. That doesn't include the increase from Iran that will come during the same time.
I don't think there will be a decline in U.S. production of 600,000, but I do expect there to be some erosion by the end of the year. My outlook is probably for about half that much based upon the quality of shale wells currently in production.
Since the emergence of the U.S. shale revolution, America hasn't gone through a recession, so it's impossible to know in the disrupted oil sector how that will have an impact on demand.
We know U.S. consumers will slow down in their consumption of gasoline and other oil-based products in a recession, but to what level and how it'll impact a market producing much more domestic oil is an unknown.
Looking to China and its economic downturn isn't an option because the data aren't reliable. China's economy is slowing down, as is its demand for oil and gas, but because it is always presented in a more positive light than warranted, we don't know how deeply demand has been affected.
Oil and gasoline consumption in India is being looked to as offsetting some of China's drop in demand, but I'm not convinced there either. It has yet to be proven, and India doesn't have near the infrastructure in place that would result in gasoline usage at the level China has. It may help some, but it won't be the positive catalyst some believe it will. A global recession would spoil that outlook in general too.
What is important when considering the recession side of the outlook is while most other countries of importance on the demand side are being analyzed with that as a possibility, the U.S. hasn't been discounted in that regard. I believe it should; at least in the sense of it becoming a reality over the next several years. Not including a U.S. recession would bring about another surprise to the downside on the demand side of oil.
Another part of the outlook is concerning the significant reduction in capex over the last year or so, which further out will have an impact on supply. That will probably be true, but it seems to be priced in at the short term at a higher level than I am comfortable with. It's not like a decline in development has an immediate effect on supply. It takes time to work its way through the process.
Also a factor is the way shale producers can develop wells and wait to bring them into production when the price of oil makes it profitable. This could offset a lot of the capex issues some are counting on to shrink oil supply over the next several years. Shale firms have continued to surprise on the production side, even after over 1,000 rigs have been brought out of production (including non-shale rigs). Why that would suddenly change in the eyes of some is a mystery to me. I understand some of the wells in production will decline, but I don't think to the levels being put forth by the IEA.
My belief is the market still analyzes oil the same way it did in the pre-shale days; that is a huge mistake it will apparently take a long time to change.
Like many other assumptions made from the wrong diagnosis of this being a supply cycle, these assumptions could prove to be very wide of the mark as well.
Report may be too negative concerning production levels
A couple of major reason I think this report may be too negative with production levels through 2021, is not only will the U.S. enjoy some solid growth, but Iran will continue to boost supply as well, with the goal of bringing production back to pre-sanction levels. If it continues with that as a goal, it would add about 2 million barrels per day to the market on top of other supply growth.
This doesn't include the growing amount of inventory that would have to be worked through once there is an actual rebalancing of the market.
With the U.S. and Iran bringing a lot more oil to the market, the conclusion of this report suggests the rest of the world is going to keep production at levels close to where they're at now. I just don't see that happening.
But if most other production were to remain close to where it is at today, it still doesn't account for how much oversupply will continue being supplied to the market. The idea of a freeze is totally meaningless because the market leaders have brought production close to capacity, and an agreement should be considered irrelevant because of that.
All a potential freeze does is generate the misguided idea it would lead to production cuts. Saudi Arabia has stated very strongly and clearly it has not intention of cutting production and allowing competitors to take away market share. This is why any freeze agreement would have little more than a short-term impact on the price of oil.
As for Russia, it has nothing to lose because it will be forced to give up a little production because of lower output from its existing wells, so it would be happening there whether or not a freeze were officially agreed to. That won't help the oversupply anytime soon. It only confirms Saudi Arabia and Russia aren't giving up much if anything by agreeing to a production freeze.
Under a healthy global and U.S. economy the outlook for oil is dismal at best. Add to that an upcoming recession, and it further dampens the outlook on the demand side, which will drop significantly as consumers and the public sector cut back on spending.
While I understand why the IEA wouldn't want to include a recession as part of its outlook, it will play a factor once it becomes a reality.
For that reason I believe the short and long term outlook for the price of oil is too optimistic, even at these low expectations. Not pricing in lower U.S. oil demand during a recession is a mistake that will skew demand expectations for oil over the next several years.
Not only do I see production being higher than the IEA is projecting over the next several years, but I see demand not increasing at the pace where a rebalancing would happen over the next year, or even two years.
Slowing economic growth, abundant oil supply, and a resilient U.S. shale industry point to this taking a lot longer to work itself out the market is starting to believe. This doesn't even take into account the billions of barrels of recoverable shale oil other countries have yet to explore and develop in the years ahead.
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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.