The Balance Between Crude Oil Supply And Demand by Causeway Capital Management
Executive Summary: The Current Supply/demand Imbalance
From peak to trough, crude oil prices plunged about 60% in 2014 – and slid again recently, testing lows of earlier this year. Excess supply, combined with a market expectation for softening global demand, has weighed on oil prices. Unlike past behavior, the Organization of the Petroleum Exporting Countries (OPEC) has not cut production to support the market price. This appears to us as a rational strategy. The resulting lower crude oil prices should spur demand and constrain uneconomic supply. We currently expect that the self-correcting mechanism inherent in the crude oil markets will likely bring about a recovery in oil prices by 2017.
At present, crude oil demand has turned up, perhaps responding to lower prices. This year, according to the International Energy Agency (IEA) July 2015 forecast, global demand growth will rise to 1.4 million barrels per day (mmbpd) after a weak 2014 when it registered only 700 thousand barrels per day (kbpd). Given the progressive downward revisions in the IEA demand forecast for 2016, we expect that annual demand growth will hold steady at least 1 mmbpd. This base level of demand assumes pressure from energy efficiency in Organisation for Economic Co-Operation and Development (OECD) regions and the drag from slowing growth in non-OECD regions. China remains the greatest risk in terms of near-term demand as their economic pace decelerates.
Global supply will likely continue to outpace demand this year due to significant production increases from OPEC and the lag in production slowdown from both US shale and from Non-OPEC, Non-US project deliveries. We believe the recent drop in oil prices will elicit the supply reaction that Saudi Arabia was seeking, and will result in significant market tightening in 2016 as non-OPEC production declines.
Due to the current oversupply situation exacerbated by an uncertain amount of Iranian barrels returning to the market in 2016, crude oil prices may drift below marginal cost of the swing US shale producers for the next 12-18 months.
However, if it becomes clear that non-OPEC supply has diminished, a Brent crude oil price of $70 will be required to incentivize sufficient US shale production to balance the market in 2017 and beyond. After 2017, an even higher oil price may be required to incentivize new supply projects to offset base declines outside of OPEC and the United States.
The Saudis are seeking an equilibrium in which demand growth remains steady and non-OPEC supply grows at a pace that meets some, but not all of this demand.
Recent Developments
As the largest OPEC producer, Saudi Arabia has historically adjusted its crude oil production to balance the global market. We estimate that the significant decrease in the “call on Saudi” production last year would have required an approximately 2 mmbpd unilateral cut in production from the Saudis to balance the market. Instead, the Saudis chose to retain market share, and let the global market reach equilibrium.
We may never know the precise reason(s) for OPEC’s failure to reduce supply in 2014. However, based on expert reports, we suspect that the Saudis were highly concerned about waning global oil demand, particularly in China. With lower oil prices creating more incentive for usage, structural (rather than temporary) demand may rise.
Other motivation for the Saudi inaction may have come from their concern about new sources of supply. In the last two years, US shale gained a significant share of the global oil supply market at the expense of OPEC and the Saudis. An OPEC cut supporting higher prices may have incentivized even greater volumes of shale production, leading to even further share losses to US oil & gas producers.
We also recognize the importance of intra-OPEC compliance. In the past, the Saudis have adjusted their production in excess of their share in order to balance the oil market, while other OPEC members enjoy higher production. With Libya, Iran and several other members producing substantially less than their historical averages, the Saudis may have received considerable pressure to cut production, allowing other members to take market share.
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