6 Oil Market Myths - Why The Price Of Oil Is Going To Recover In The Medium Term

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Includes: BP, CVX, E, XOM
by: Mantas Skardzius, CFA

Summary

The market consensus is fairly bearish, mainly based on views that may be only partially true.

Demand side is strong, inventories not as abundant and the supply capacity is limited at the current price.

Taking all into account, the higher oil price is needed soon to avoid the supply crunch.

If one was to follow the media, the consensus for the oil market is pretty dim - OPEC is obsolete and fractioned, inventories are plentiful, US shale is rocking the market big time and - the mother of all bearish arguments - the long term prospects are ever-worsening due to the EV/Hydro fuel craze.

Some of these ideas floating around are true, other are not. Therefore, while the many parts that are moving in the oil market may confuse one too much to jump to quick conclusions, let's take the predominant myths one-by one and try to discuss them in turn.

Myth #1: Slow economy and efficiency gains have restrained the global demand

No

Pre-crisis investors are surely familiar with the media mantras of "Commodity super-cycle" or "Peak Oil" as the rise in Chinese/Asian commodity demand has caused the havoc in the commodity markets just as the supplies were relatively inelastic. Unsurprisingly, the prices have corrected upwards so as to reflect the mismatch, attracting the media attention, speculative capital flows and even retail investors, religiously voting with their money for the "Peak Oil" story.

Billions of dollars burned-later, the growing global demand for oil is unduly forgotten.

In fact, the hunger for oil is possibly the only stable rain-or-shine part of the equation in the oil market. Measured in millions of barrels per day (mbpd), the global demand for crude oil currently stands at almost 98 mbpd - having risen, on average, by 1,3% a year during the last twenty years since the Asian crisis.

Surprisingly, physical demand dynamics haven't changed much during the boom-bust years as the global demand kept ticking up at the similar pace during the pre-crunch just as during the post-crunch years.

As the global economy recovers, the demand - already growing at the above-average rate - should accelerate even further, thus making sure the demand side of the market stands stronger than ever during the last twenty years.

Bottom line, IEA expects the global demand to grow to 104 mbpd by 2022 with almost all growth in demand coming from the Asian nations and the looming question over the industry is where these extra barrels will come from.

Myth #2: There's plenty of oil in the inventory

Yes, a "cautious yes" and "who knows?" - depends on what you're looking at

Though the most transparent and liquid in terms of trading, the US market is losing its market share of the consumption and the center of gravity is shifting gradually to the far east. As of today, the US consume almost a fifth of global oil output - undoubtedly impressive, but the market share of the consumption has been constantly skimmed away from the levels of ~ 25% in 2003.

Having said that, the most easily accessible data for the market is the American oil stocks data and the common practice is to check the American inventories and presume that, more or less, the situation is just the same in the remaining 80% of the oil consumption market, roughly speaking.

To make things comparable, I simply divide the crude oil stock by the daily consumption to come to the indicator widely used in other commodities markets - days-to-use ratio. Apparently, the longer the country can sustain itself from the crude oil stock, the more plentiful inventories are.

That way we calculate this oily day-to-use ratio for the American market with a major focus on the change in inventories, rather than the absolute level.

It may not be the glut, but the relative inventory levels are surely elevated. Relatively speaking in terms of daily crude oil demand, the inventories have risen almost twice (+92%) since 2003 with major gains during the last two years, which is a lot.

Should we extrapolate that kind of dynamics onto the rest of the 80% world's consumption, we could easily end up having a truly bearish view on the short term oil outlook.

That is not the case, however, as data from the broader region does not confirm the extreme inventory rise in the US. Let's look at OECD - a broader aggregate for the mostly developed 35 nations (including the US), which account for roughly half of the global daily crude oil consumption.

In terms of OECD days to use ratio, the oil doesn't seem that plentiful anymore - despite the reduction in absolute oil demand, the ratio has increased only one-third of the American counterpart. In turn, that implies that the so-called supply glut that the market is following in the US is not actually a good benchmark for the global extrapolation. Rather, the American inventories is just an extreme case in the global context and the developed countries are not swimming in oil as the American data could indicate.

However, the ultimate wild card for inventories is the situation in the developing nations as the story is fairly scattered and we are confined to the "known knowns" and the "known unknowns" (still making the story a good third easier to follow than for Mr. Rumsfeld! )

What we actually know about the Emerging Markets is that the demand is going strong - it is going forward so well that it is projected not only to comprise bulk of the future growth in global demand but to compensate for the reductions in the more mature consumption regions (namely, OECD).

What we know that we don't know is the inventory part of the story - it is tricky to get hands on a reliable data and we're left with the crumbles that major countries are sharing. It would be logical to assume that major countries (namely, China) are stocking up in effort to take advantage of the low oil prices. However, it is hard to come up with any kind of conclusion in terms of how that compares to ever-rising physical demand in those markets (Asia, after all, will be responsible for the lion's share of the oil demand growth in the upcoming years).

Myth #3: OPEC Spare capacity is large

No

OPEC surplus capacity - the amount of oil that could in theory be readily delivered to the market - is not exactly that large bearing in mind all the "keeping the market share" talk since 2014. Currently, the surplus capacity hovers around the very same levels of 1-2 mbpd as during the supposedly tight years of 2006-2007. In that sense, the oil is actually scarce and the ability to meet the unexpected demand or compensate for the supply disruption is comparatively low.

Myth #4: Low oil price has killed the investment

Yes

The belt-tightening during the recent years in oil exploration and drilling activity could serve as a textbook example of economics in action.

The cuts have been carried out across the industry:

- Shale players have cut their activity simply because they could not afford it anymore - small US shale plays being a leveraged operation with the high cost base of extraction (averaging anywhere in between 40-80 $ per barrel).

- Big oil (XOM, CVX, RDSA, BP, Total, E etc.), while having the resources to proceed with the diversified portfolio of projects they usually have (onshore, offshore, deep-water), have overly prioritized the current dividend payments to its shareholders over future capacity growth, thus scrapping the projects en masse.

While the ability and determination to cut is impressive, that has resulted in one of the slimmest records of new conventional capacity growth in recent history. One could argue that in general that does not solve anything - it does not help to balance the spot market (as the current supply goes on), but it does deepen the future shortage should the supply/demand balance turn the other way some years from now, as it takes around 6-7 years to get the new substantial oil project going.

Myth #5: The physical spot oil market will stay in surplus for the foreseeable future

No

US shale may prove to be buoyant once again, Libya, Nigeria and Iran may increase their output, but the rest of OPEC is showing at least an attempt at implementing the cut quotas and the demand is relentlessly marching forward.

In turn, the physical oil market has already passed the oversupply phase during 2015 and 2016. Recently, things have got much tighter, as the demand side has pretty much caught up with the stalling supply and the physical oil market is about to have its first serious deficit in 2017 2Q. It ain't the scarcity yet, but it may signify the end of the beginning for the oil cycle.

According to IEA projections, the things are about to get much uglier in the years ahead, as the restrained supply is unlikely to keep up with the growing demand.

Under the projection that the oil stays at 58$/barrel, the difference between the projected growth in demand and the supply in the coming years is going to wipe out the entire OPEC surplus capacity, thus not only reducing the capacity levels to the bare minimum, but also increasing the stress level (and the "supply stress price premium" of the spot oil price) as well as the volatility-bearing attention to any supply disruptions.

Should the price stay at current levels for longer (instead of 58$ used in the IEA model), it would make sense to assume the upcoming supply crunch to take the more extreme turn as the 40-something-dollar oil would certainly create the larger deficit than the OPEC surplus capacity could cover.

Myth #6: US Shale will cover the gap to keep the status quo

No - not at this price

Although getting lower, the costs of exploring and drilling the oil from the US shale is an expensive stunt, ranging, arguably, anywhere in between 40-80$ per barrel depending on the well. Reaching lower cost levels of even 30$ per barrel may prove to be true some day, but even that would be a far cry from the costs levels of the Middle East onshore projects (3 - 7$ per barrel).

For that reason, US shale is even more sensitive to the oil price and the supply is relatively elastic - bulging every time we got the pickup in prices and shrinking whenever the prices are low.

Based on the IEA 5-year projections, the US production of LTO (light tight oil) in 2022 will depend heavily on the prevailing market price for crude oil. Should the price stay close to the base scenario (around 60$ per barrel at the time), the supply should elevate a bit by 1-1.2 mbpd of crude with much higher supply (+2.8-3 mbpd) in case of higher oil prices (around 80$).

The interesting point, though, is that US shale drillers are not going to pump the black stuff out at any price in vast quantities - if the price of oil stays low, as it is now, the amount supplied to the market in 2022 will be about the same as in 2017, having peaked in 2020.

Simply speaking, at the current crude oil price, we can virtually cross out the US shale growth out of the equation - making the upcoming physical supply deficit even worse and totally dependent on the conventional oil supply, which, recently, has been badly deprived of investment.

Conclusions

Despite the potential long-term headwinds, the medium term outlook for the crude oil demand is as strong as ever. While the demand is growing in a rather stable manner, the supply has been rocked by the US shale, causing the physical oil spot oversupply, reducing the prices and eventually killing off most of the new capacity investment.

With demand still ticking up and investment so low, the physical oil market seems to be headed for a supply crunch in the foreseeable future. To avoid the scarcity, higher oil prices should re-emerge as a balancing factor. However, due to the nature of oil projects, the scarcity may extend for longer, thus causing relatively high volatility on supply disruptions. Looking at fundamentals, crude oil price seems to be at the low end of the "overshooting" story in the oil market - while the three-figure-oil is a distant dream, a healthy recovery is perfectly possible in the near future, thereby giving some tailwind to the entire supply chain.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.