In recent weeks, renewed trade concerns, slowing oil demand, and a notable acceleration in implied U.S. oil production have spurred a material sell-off in oil. Similar concerns caused oil prices to drop at the end of last year, which prompted OPEC+ (i.e., the Organization of the Petroleum Exporting Countries plus 10 additional oil-producing nations) to cut production, reversing policy set earlier in the year of increasing output ahead of a reintroduction of sanctions on Iran.
While OPEC+ output is now near multiyear lows, we do not believe OPEC will abandon the production accord at its upcoming meetings in Vienna (likely in the first week of July) in order to meet revenue targets, given that last year's experience - boosting output and needing to reverse course soon after - will be informing its decisions. Moreover, actual U.S. oil production may not be as strong as the implied data suggest.
All told, we believe this sell-off is overdone and that the current backdrop offers an attractive opportunity for investors, whether via owning commodities outright or via midstream investments.
Complicated backdrop: trade, production
Oil demand is quite leveraged to global trade and, as such, has lost demand momentum as global trade has faltered. Over the past month, markets have answered the trade tensions and repriced the likelihood of a U.S.-China deal, which in turn may drive some upside to oil demand. However, a recovery in economic activity would likely be a prerequisite for meaningful price appreciation in the near term. Longer term, the upcoming shift in the International Maritime Organization-imposed sulfur cap to 0.5% from 3.5% in waterborne shipping offers a positive catalyst for crude oil demand, particularly light sweet crude.
Another area of uncertainty is the speed of U.S. production growth. Real-time data is limited; the U.S. Department of Energy (DoE) bases weekly production estimates on lagged monthly data, which is subject to revisions long after initial publication. Petroleum economists often augment the lagged production data with an implied production estimate, calculated by including the unidentifiable portion of the oil balances with production.
It is this latest string of implied production estimates that we find especially intriguing - and controversial: After largely flatlining during winter months, in part due to weather, U.S. implied production has surged from roughly 12 million b/d (barrels per day) in March to nearly 13 million b/d in May. This rapid increase, if real, would be unprecedented, and (remarkably) would have come just before new pipelines are set to ease the bottleneck in the Permian Basin.
Drilling into the implied data
Could U.S. production really have grown so quickly without a material increase in pipeline capacity? While producers continue to exceed expectations, it is curious that most indicators have not been directionally consistent. Specifically, daily natural gas pipeline data from oil plays has largely shown little growth the past five months, unlike last year, when output of both gas and oil were surging. Rig counts, unlike in 2018, have been falling, down 10% from December highs (according to Baker Hughes).
In addition, estimates of completion activity in U.S. hydraulic fracturing have largely been flat the past 12 months (according to Primary Vision). Also, our top-down corporate sampling and bottom-up basin estimates struggle to corroborate this implied production surge. Lastly, physical crude oil has consistently been trading well backwardated (i.e., with a downward-sloping futures curve) in the Gulf Coast - typically a sign of a tight physical market - and Midland Basin prices have been improving as new pipelines near completion.
Implied output can be volatile, and we find this apparent surge in U.S. output tough to explain. But with U.S. inventories building sharply over the past two months, rising U.S. output could once again hit the market, as it did in the second half of 2018. As new pipelines come online this year, just how far U.S. output will be above our year-end expectations of 13.4 million b/d will shape the oil price path.
Investor takeaways: midstream energy, roll yield
Looking ahead, we see two potential opportunities for investors. One is the U.S. midstream energy sector, which is the primary beneficiary of U.S. oil production growth due to the need to process, transport, store, blend, and export. We believe the midstream sector offers organic growth well above nominal GDP growth, along with attractive yields and attractive valuations.
Another strategy is to buy oil, typically via an allocation to a diversified commodity index with meaningful allocations to petroleum. Due to OPEC+ actions thus far, both voluntary and involuntary, the oil market remains quite backwardated, contributing to a positive "roll yield" for investors owning oil in addition to potential collateral yield. The likely commitment to continuing the OPEC+ production agreement should allow for this curve structure to remain. Roll yield has been a strong indicator of forward returns historically, and if the global economy remains on track, we see a similar opportunity today.
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