October 23, 2018Oil prices have come a long way since early 2016, when Brent
was collapsing to below USD30/bbl. Tighter market balances have since driven Brent
to around USD80/bbl, though the combination of OPEC supply and MARPOL demand
disruptions could tighten markets even more, putting further upward pressure on
prices. While the industry usually absorbs some of the disruption, current low
effective OPEC spare capacity and infrastructure constraints in the US could
reduce the industry’s ability to immediately respond to potential supply and
demand disruptions, leading to a USD100/bbl+ world. However, the sustainability
of such a high price remains questionable as infrastructure bottlenecks are
expected to subside and the global economy faces downside risks.
Continuous socioeconomic turmoil in OPEC may shave >1.5 MMb/d from the supply stack
1. In the near term, Iran poses the largest downside risk in terms of volume (700-1,200 Kb/d) due to sanctions re-imposed by the US, and purchases of Iranian crude by Asian countries and European companies have already slowed considerably. According to Bloomberg, Iranian crude exports are down by 1 MMb/d compared to April 2018—the lowest levels since March 2016. Some of the surplus supply could find a temporary home in floating storage (as of mid-September, it totaled ~13 MMb). Nevertheless, crude production has begun to be affected by the decline in exports, dipping by 420 Kb/d in the last 6 months to 3.4 MMb/d. Using the 2012-15 levels as a proxy for Iranian production potential under sanctions, a further fall of at least 700 Kb/d—to 2.8 MMb/d—could be envisioned.
2. Venezuelan crude production is expected to decline by another 300-500 Kb/d as the country’s socioeconomic crisis continues. Following years of economic mismanagement and chronic corruption, Venezuela is grappling with mass emigration, goods shortages, a USD50-billion international bond default, a humanitarian crisis, and hyperinflation that is expected to hit one million percent by the end of 2018. Consequently, production as of September has fallen below the 1.3 MMb/d mark—down from over 2 MMb/d only two years ago [2]. The compounded monthly decline rates in oil production reached 3% in H1, sharply up from 1.8% in 2017 and 1% in 2016. Considering this trend and the reduction in the number of active rigs by ~50% y-o-y, further production decline is likely. Joint Sino-Venezuelan investment in the Orinoco belt can offer some temporary relief, yet it is unlikely that Venezuela will succeed in materially expanding production within the next 6-12 months as all other forms of investment are halting.
1. Internal Libyan strife between key political factions can temporarily knock off 300-700 Kb/d in production and exports. Mired in an internal power struggle regarding distribution of oil revenues, Libya has been the largest source of unplanned production outages for most of the past three years. Blockades—both physical and legal—of port terminals and oil fields periodically affect hundreds of thousands of barrels of production and exports. Recent examples include terminals Ras Lanuf and Es Sider going offline in June and July, affecting exports of up to 400-450 Kb/d, and the Zawiya terminal stopping operations in August (>300 Kb/d). While neither of these disruptions lasted more than two months, their magnitude and unpredictability affect both perceptions and fundamentals, as downstream operators and traders find it difficult to rely on Libyan supply.
Higher-than-expected MARPOL compliance could increase crude demand, exacerbating market tightness by 2020
MARPOL regulations could add up to 0.2-0.5MMb/d crude demand on top of the projected end-user MARPOL-driven demand growth of ~0.6 MMb/d. MARPOL regulations will tighten the marine bunker sulfur limits, which should shift the product mix to favor marine gasoil at the expense of fuel oil for the ships that do not install scrubbers. The global refining system is expected to struggle to accommodate such a change in short time, as it requires expensive and time-consuming capital investments to refining configuration modifications. As such, refineries are likely to increase crude runs in the short term to meet new demand. In a world where marine gasoil covers 40% of the additional marine liquids demand, demand for crude should increase by ~0.6 MMb/d. Yet if gasoil share increases to 75%, then additional liquids demand due to MARPOL might even reach 1 MMb/d.
Industry’s ability to respond to these disruptions is constrained until 2020, given low spare capacity in OPEC and pipeline constraints in the US
OPEC’s ability to address supply shocks is limited by untested spare capacity in Saudi Arabia, Kuwait, UAE, and the Neutral Zone. Currently, Saudi Arabia’s spare capacity is estimated at >2 MMb/d, potentially insufficient to cover the supply gap should multiple acute disruptions occur simultaneously. Furthermore, production at full nominal capacity has never been tested by Saudi Arabia, and the country’s August production levels were just 300 Kb/d lower than the maximum historical level of production (10.7 MMb/d). This trend was also present in Kuwait and the UAE, where August production levels were just 200 Kb/d below historical peaks. In addition to this, OPEC’s supply margin includes the Neutral Zone and 400-500 Kb/d that could be brought back online in early 2019. This raises the question of how reliably and how quickly OPEC’s spare capacity be turned on, should an intervention be needed.
US shale oil output is typically very responsive to increases in oil prices, but pipeline and services constraints—particularly in the Permian—are likely to limit the ability of shale operators to respond quickly enough to high prices. We expect takeaway capacity constraints to continue to limit the shale oil production upside unless there is coordinated action from operators in the next few years. The issue is particularly acute in the Permian basin, where the pipeline and railroad systems are approaching maximum throughput. In 2019, we expect Permian production to exceed even the rail capacity, resulting in substantial differentials as truck capacity is needed, likely depressing production for 6-12 months even if the global oil prices remain high. Up to 300 Kb/d in new shale oil production could be at risk by mid-2019, a figure that can expand to 500 Kb/d by the end of the year if capacity additions are delayed.
However, higher prices are unlikely to be sustained beyond 2020 due to infrastructure improvement in Saudi Arabia and the Permian and changes in the global economy
Saudi Arabia has already announced a USD20-billion investment in maintenance and possible expansion of its spare capacity over the next few years. The Kingdom is also planning to bring online two fields with over 500 Kb/d output later this year, which is not expected to raise its total capacity but should still boost the country’s output flexibility. Current public communication from Saudi leadership highlights their intent to maintain their output and spare capacity flexibility, allowing Saudi Aramco to extract oil at politically and financially favorable production levels.
In the Permian, four new pipelines will be gradually added after 2019, debottlenecking the basin post-2020. Planned pipeline capacity expansions include Sunrise, Cactus II, EPIC Crude, and Grey Oak. Under current projections, Permian takeaway capacity can easily grow by 0.5 MMb/d per year up to 2022 with current announced capacity additions, adding supply source flexibility to oil markets.
Finally, increased oil substitution and an economic slow-down driven by high oil prices but also recent events could ease demand, thereby limiting the upward trajectory of oil prices. Historically there is evidence that higher prices encourage investments in substitute fuels, as they affect access to oil for a rising middle class. Electrification is already reducing oil demand, and a 100-dollar oil world will accelerate this transition.
On top of electrification, USD100/bbl oil prices combined with current bearish projections for the global economy could also provide downward pressure to oil demand and oil prices; we witnessed it in 2008-09. Historically, high oil prices have negatively affected economic growth, as both the consumer basket and industrial activity become more expensive. Such a downward effect to the global economy would be coming at the wrong time; according to Bloomberg, most investors are bearish towards economic growth, believing the economic expansion is in its late cycle. Bearish projections are based on recent events: recent interest rate spikes by the FED should drive a higher dollar, potentially leading to an economic slowdown, particularly in emerging markets. What’s more, the IMF estimates that global GDP growth could be negatively affected by 0.5% in 2020 if the US trade disputes continue.
When all these factors are combined, it seems unlikely oil prices can stay at USD100/bbl+ for a sustained run. While the oil markets have always been sensitive to shocks and should continue to be so, there do not seem to be any fundamentally structural changes pointing to a return to expensive oil.