After last year’s oil-price rebound, many investors wonder whether the recovery is over. Probably not. As global demand increasingly relies on US shale, we think oil prices could touch $80 by the end of the decade.
Wild Ride Since Mid-2014
It’s been a rocky few years since June 2014, when the price of Brent Crude oil stood at $115 per barrel. Over the next 18 months, oil fell to a trough of $32 in January 2016 before recovering to trade at more than $55 this month—about 72% higher than year-ago lows.
Many analysts think that oil can’t get much higher than $60?$65 a barrel in the next three years. Our research suggests that these projections underestimate the costs of producing oil in order to meet demand growth.
Strong Demand, Fading Non-US, Non-OPEC Supply
Over the past four years or so, global demand for crude oil has increased by roughly 1%?2% per year, peaking at 2.4% growth in 2015. Projecting through 2020, we see a steady 1% annual rise in demand.
On the supply side, members of the Organization of the Petroleum Exporting Countries (OPEC) have until now met much of the annual increase in demand. Production of non-OPEC, non-US oil-producing countries has declined, while US production has started to recover recently from a decline over the past two years.
Looking ahead, we expect OPEC production to rise modestly from 2018?2021. Non-OPEC, non-US oil volume should decline slightly and US oil production should grow more substantially (Display).
Within OPEC, Iranian oil has already come back online post-embargo and there’s little scope for major investments needed to grow capacity. Saudi Arabia has used up its spare capacity in its effort to drive down global oil prices and make it less economical for US firms to develop shale reserves. And other oil producers, including Venezuela, Nigeria and Libya, have their own production challenges.
Outside OPEC, non-US oil producers will struggle to generate more supply. With oil below $50 a barrel until recently, investments in new oil reserves just weren’t profitable. Since new exploration and production (E&P) takes a few years to bring online, that lack of investment could suppress oil supply levels for years. In other words, the impact of low oil prices in 2014?2016 could be felt for years through decreased supply.
Against this backdrop, US oil production will be essential to meet steadily growing global demand for oil, in our view. This means that in the coming years, oil prices will be increasingly determined by the costs of extracting that oil from various US shale deposits.
Shedding Tiers of Shale
In recent years, US shale production was affected, along with the rest of the industry, by lower prices. US shale activity declined in synch with the falling price of oil from the summer of 2014 through early 2016.
As oil prices fell, E&P companies drilled fewer wells, but focused on more efficient shale wells. The US shale drilling locations are grouped into tiers based on their level of productivity and economics. Since tier 1 locations produce oil more economically, E&P firms can access them at much lower cost. These tier 1 wells made up 38% of the oil wells in the first quarter of 2014 and have grown to 49% of the mix today.
It’s great news that the oil shale E&Ps have become more productive. Unfortunately, there are only so many tier 1 shale sites, and based on current estimates, all 26,000?27,000 of these sites will be depleted halfway through 2019. Furthermore, as US activity ramps up, the cost of drilling and completing a well will rise.
If this plays out, E&P firms would then need to shift their attention to tier 2 locations, which are less efficient. Our research indicates that the cost of drilling profitably at these locations would require WTI crude—the key benchmark for US oil prices—to reach $78 a barrel by late 2019, when accounting for inflation of drilling costs (Display, upper line). At current costs, as shown on the lower line, the breakeven price is about $45 a barrel. And since the world will be looking increasingly to the US to meet ongoing demand by 2019 and beyond, we think the economics of drilling at tier 2 sites will start to set the oil price in 2019.
Of course, there are risks to our assumptions. An unexpected recession could undermine demand. OPEC could surprise with much higher production. And new technology could theoretically uncover more tier 1 shale locations.
But based on what’s known today, the oil-price rebound is far from over, in our view. As the long-term recovery unfolds, we believe energy stocks—especially oil producers and oil-services groups—could continue to outperform. With a selective approach to the sector and a greater understanding of global supply/demand dynamics, investors can position equity portfolios to benefit from a potential long-term increase in oil prices driven by the often misunderstood economics of shale oil.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
Article by Joseph G. Paul, Akhil Kapoor – Alliance Bernstein
