Oil At $70 – How Will The Markets Rebalance?

OPEC’s recent decision to let oil markets balance themselves has a broad range of implications for the energy sector and the broader economy. While there are several levers available for the market to rebalance, U.S. shale activity should prove to be the most important supply variable.

Historically, oil supply and demand have been somewhat elastic. Lower prices encourage stronger demand and a reduction of drilling. While it is often said that low oil prices are the best cure for low oil prices, there’s a potential wrinkle in the current environment. U.S. tight oil or shale has a shorter investment cycle than most conventional projects, which have historically driven oil supply. Additionally, OPEC has usually stepped in to balance the market, a safety-net that no longer appears to be in place.

Supply Levers

In the short term (next 12 months), there are two available supply levers to balance the market outside of OPEC: a reduction in U.S. shale oil supply, and lower production from vulnerable nations such as Libya and Iraq.

The recent decline in oil prices will lead to lower levels of U.S. capital spending due to a reduction of discretionary cash flows. Ultimately, a slower pace of U.S. production growth than previously expected will result. Reductions in spending today will most likely not impact production until late 2015, creating the possibility for further downside risk to oil prices in the near term. U.S. production will be important to monitor given the shorter cycle nature of shale and the need for a supply reduction to balance the market.

Unplanned outages from Libya, Iraq, Iran and others have been at historically high levels since 2011, and the supply from Libya continues to be closely watched. Production from Iraq, and eventually Iran also remain difficult to predict.

Longer-term, supply reductions could come from reduced investment from non-OPEC countries outside of the U.S. (onshore). There have already been signs that several major oil and gas exploration projects have been put on hold as a result of lower prices, including projects in Canada, Venezuela, the Gulf of Mexico and the North Sea. Given the lengthy timeline from final investment decision to first production for major capital projects, the impacts of such decisions will not be felt for several years, but should result in less future supply.

Within OPEC, while difficult to predict, members could still choose to reduce supply or call for stricter compliance with OPEC’s current quota. This could be either officially, when it meets in June, via an emergency meeting, or perhaps Saudi Arabia could quietly reduce supply on its own. However, in the near term, the lifting of Iran sanctions and a recovery of oil volumes in Iraq will likely continue to weigh on oil prices.

Demand Levers

Lower oil prices should translate into higher demand, both as a direct result of cheaper petroleum prices and through the second order effect of higher global GDP growth, which in turn drives oil demand. Average gasoline prices in the U.S. are now around $2.75 per gallon, compared with the $3.25-$3.90 range over the past four years. In local currencies, many other countries including Canada, Europe, India and China have also seen significant declines in prices for gasoline and diesel. The IMF has estimated that a 25% decline in oil prices could result in a 450 thousand barrel per day increase in oil demand, or roughly an increase of +0.5%. Keep in mind that several factors could serve to offset this higher demand – seasonal trends, the removal of subsidies in many countries (Thailand, Malaysia, India), rising energy conservation, and the devaluation of many emerging market currencies. Nevertheless, we should see some additional demand as a result of lower prices.

The largest risk on the demand side for oil is a continued economic slowdown. As recently as this summer, expectations for global oil demand growth in 2014 were as high as 1.3 million barrels per day. Now the IEA’s most recent estimate calls for 2014 growth of only 680 thousand barrels per day—a five-year annual low. The downward revision was in part based on the IMF’s estimates for slower global economic growth and as a result of lower growth in Europe and Asia. Oil demand growth for 2015 is currently estimated at 1.1 million barrels per day, based on a better macroeconomic backdrop.

Given the capital intensive nature and long lead times of the oil industry, oil markets rarely stay in perfect equilibrium, but rather overshoot in both directions as we saw before and after the global financial crisis. The entrance of U.S. shale could lead to a smoother and faster self-balancing mechanism longer term, but in the short term, the absence of OPEC will make it difficult for oil markets to correct themselves.