- IEA, EIA projections point to significant supply growth in 2018.
- However, global upstream investment remains depressed as the market relies almost exclusively on anticipated growth in US output to meet growing global demand.
- Offshore oil production accounts for 30% of total global oil production and as such remains a key component of the global oil market.
- Investment spending in the offshore sector remains well below prior peak levels from 2013/14.
- If US production growth slows or tops out (a possible scenario by 2020), a severe global supply deficit in the oil market may develop from 2020 onwards.
In this article we will take a closer look at the latest data and forecasts published by the International Energy Agency (IEA), as well as the Annual Energy Outlook (AEO) published by the Energy Information Administration (EIA). The IEA data will give us a clearer picture of the current state of the global oil industry and more specifically, the outlook for the next two years. The AEO publication will offer us a longer-term perspective and perhaps notably, as we will discuss later in this article, lead us to the conclusion that a significant disconnect exists between valuations in the U.S. onshore Exploration and Production (E&P) sector (NYSEARCA:XOP) and the forecasts that underpin the AEO' s long-term reference case.
In the IEA's monthly publication, the Oil Market Report (OMR) has taken an optimistic view with regard to growing oil output in the U.S, while also forecasting a modest reduction in global demand growth in 2018. In its most recent OMR publication (February 2018), the IEA said that it expects global demand to grow by just 1.4mn bpd in 2018, a modest decline from the 1.6mn bpd growth reported in 2017. On the supply-side, the IEA expects total global oil output to grow by 1.7mn bpd, with 1.35mn bpd of incremental output coming from the United States.
The IEA's assumptions are quite aggressive and would point to a market that will remain prone to excess supply or output growth. Notably, the IEA's assumption regarding U.S. production growth is even higher than the EIA's projection, which is forecasting growth of around 1.2mn bpd in 2018. We would probably defer to the EIA in terms of accuracy in forecasting U.S. production and as such, would suggest that the lower figure is a more reliable forecast for 2018. Furthermore, as outlined in this prior article, we believe there remains some downside risk to the EIA's growth production estimates.
Global output averaged 97.7mn bpd in December 2017 and January 2018, lower than the average of 98mn bpd in October and November 2017 and despite the relative increase in U.S. production over the past four months. Declining production in Venezuela and some temporary outages in the North Sea have been the main reasons for the recent decline in output. As such, and assuming some rebound in production from these regions in 2018, we can probably work off an output base of 98mn bpd for Q4 2017.
Global demand averaged roughly 98.4mn bpd during H2 2017 according to the latest data from the IEA, suggesting that the market was in an overall supply deficit during the second-half of 2017. As such, using 98.4mn bpd as our base for global demand in Q4 2017 seems reasonable. If we further assume that global demand will match the growth in consumption during 2017 (1.6mn bpd) it would imply an indicative demand figure of 100mn bpd will be reached by Q4 2018.
As a result of the temporary decline in output from Venezuela (we assume temporary but there is no reason to believe that a meaningful rebound will materialize in the near-term) and the North Sea, OECD oil and petroleum product inventories declined sharply during Q4 2017, in fact falling by 55.6mn barrels in December alone. The decline in inventory levels during December constituted the steepest drop since February 2011. As a result, total OECD inventory levels declined to 2851mn barrels and ended the year just 52mn above the five-year average.
So if we further assume that U.S. production will grow by 1.2mn bpd (as per the EIA estimate) in 2018 and we also assume that the IEA will be correct in its optimistic forecast for non-U.S. and non-OPEC output growth of 350,000 bpd (doubtful*), then total global output growth will reach roughly 1.55mn bpd , essentially matching anticipated demand growth. This will translate into an anticipated global output level of around 99.5mn bpd in Q4 2018, which still leaves the market in a supply deficit. Naturally, all of this assumes that OPEC will retain its current level of production throughout 2018, which may not be the case.
Nevertheless, an average supply deficit of 400,000 bpd in H2 2018 would lead to a further decline in OECD inventory levels of around 72mn barrels, and would take inventory levels below the five-year average. As also discussed in this same prior article, it is worth remembering that there is a severe distortion in the type of incremental crude oil supply that will come onto the market from the U. S., being mainly lighter oil or condensate. We don' t have reliable data on the composition of OECD inventory levels (in terms of API), but it would be safe to say that by the end of 2018, inventory levels for heavier crude types could be significantly below the five-year or even 10-year average.
*If we look at some independent data on global upstream capital investment we can see that total capital spending is likely to remain below prior peak levels until at least 2020/21.
Source: McKinsey Energy Insight's Global Liquids and North American supply models
In fact, if we narrow in on capital investment in the offshore segment, the decline has been even starker.
Source: Subsea 7 investor presentation, please refer to following article for definition of a "Subsea Tree".
Offshore oil production accounts for roughly 30% of total global oil output (29mn bpd) of which deepwater accounts for roughly a third or 9mn bpd. The average reported decline rate for offshore oil fields is between 5% and 9%, which means that some 1.5mn bpd and 3mn bpd in new capacity is required annually, solely to keep net oil output flat. Given the reduced capital investment (particularly in the offshore segment) over the past few years, it is hard to imagine that non-U.S. and non-OPEC oil output will show incremental net growth sufficient to offset existing natural decline rates.
However, even if the IEA is correct in its projections for 2018 and the oil market therefore remains fairly balanced, the longer-term outlook is even more uncertain. Taking a look at the most recently published AEO for 2018, the EIA itself expects U.S. oil production to top out by 2020-2021 at around 12mn bpd. This scenario is based on its 'reference case' which is in turn is based on an assumption that oil prices trend higher towards $80-$90 over the next four years. Although growth from the various" shale" basins will be significant, some of the additional output growth will also be required to offset the decline in US conventional oil output over the next five years.
Source: EIA, AEO 2018
What does this imply? Even if supply growth manages to exceed demand growth in 2018, this is unlikely to hold true looking out to 2019 and beyond, assuming oil prices remain below $60 per barrel. Given the long lead time for many offshore projects (not to mention large upfront capital investment), there is a real risk of a severe supply deficit emerging in the period between 2019 and 2022 as U.S. production flattens out, but non-OPEC and non-U.S. oil output remains flat.
Naturally, this is exactly what OPEC and perhaps Russia are waiting for as this will enable them to once again ramp up production into a sustained supply deficit. However, the question that remains is by how much can OPEC and Russian ramp up output, at least over a shorter time period? Most analysis suggests that OPEC could increase production by 1mn bpd over a short time period, so if U.S. production manages to grow by another 1mn bpd in 2019, then a more severe supply deficit will possibly or likely only emerge in 2020.
However, what is perhaps notable is that many of the existing OPEC members are currently still producing at near record levels not dissimilar to the production levels reported in 2015 and 2016, and before the imposition of the so-called production cuts. In fact, based on the data reported by the IEA, production in 2017 (a full-year of production restraint by OPEC) was higher than in 2015, during the infamous 'market share' war. In reality, it is only Saudi Arabia and other Arab Persian Gulf states such as the UAE and Kuwait that have implemented meaningful production cuts, and even in this case, production in 2017 was generally higher than the average production reported in 2014.
Source: IEA, Oil Market Report
So the assumption that OPEC can immediately ramp-up production by 1mn bpd in a short space of time is probably flawed. In fact, it is worth noting that OPEC "spare capacity" remains close to the lower end of the recent historical range as reflected in the graphic below. Given some of the geopolitical risks in regions such as the Middle East, there remains a real risk of a supply disruption and spike in global oil prices, should global oil inventories continue to decline over the next two years.
Source: EIA, Short-term Energy Outlook
Therefore, the available data suggests that in the best-case scenario, anticipated growth in global oil output as well as the termination of the OPEC production agreement will match the forecasted growth in global oil demand in 2018 and 2019. Beyond that point, should oil demand continue to grow at around 1.5mn bpd and assuming prices remain below $60 per barrel (thus leading to continued subdued investment levels), the market could experience a more severe supply deficit.
Forward-looking investors should not be focused on what oil prices will do in 2018 when making an investment decision regarding the energy sector. With many oil companies having already hedged a significant portion of their 2018 production, it is largely irrelevant whether or not oil prices temporarily decline to say $50 per barrel over the next 6 to 12 months. Furthermore, we would point out that thus far this year (despite the expected supply onslaught) the oil market still appears to be far tighter than was the case one year ago, given the continued decline in US inventories during a period that traditionally sees a build in inventories.
What should be relevant for investors, is that even the more sanguine EIA concedes in its recent AEO that in order for US oil production to meet current lofty growth expectations, global oil prices will eventually need to trade higher and back towards $80-$90 per barrel by 2021-22. Therefore, as we have detailed at length in this article, US production growth and the expected attainment of output levels around 12mn bpd by the end of 2019 will be critically important in maintaining a semblance of balance in the global oil market over the next few years.
U.S. E&P companies with larger reserves that are able to grow or at least maintain production at price levels of between $40 and $60 per barrel therefore stand to benefit enormously. In this context, the current disinterest in the sector is somewhat confounding and perhaps at least partially explained by lingering narratives that include concerns over the business model or ability of U.S. shale E&P' s to generate sustainable free cash flows, and ultimately, concerns over the erosion in demand growth from the growing Electric Vehicle (EV) market. In our next article we will focus more closely on some of these narratives and assess the investment merits of the US shale E&P sector.
This article was written by
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