Oil continues to make headlines this year as price volatility has shone a light on uncertain supply and demand dynamics as well as continued geopolitical risks.
Headlines and threats of a supply increase have recently caused oil prices to go lower, but we do not expect the drop to be sustained. Capacity constraints among OPEC participants make it difficult to imagine the supply gap being filled, while fundamentals remain buoyed by robust demand both inside and outside the US. We project OPEC to move slowly with supply increases - if they move at all - during their June 22nd meeting and we anticipate Brent crude moving above recent highs with a possibility of reaching $85/bbl over the summer months. Oil and energy equities look attractive and any pullback may present a buying opportunity for investors to consider.
Fundamentals & Seasonality Supportive of Prices
Since the OPEC-led production cuts began in January 2017 approximately 340 million barrels have been removed from the market (see Figure 2). According to the International Energy Agency (IEA), the Organisation for Economic Co-operation and Development (OECD) commercial stocks have fallen approximately 20 million barrels below their five year historical averages and reached their lowest levels since March of 2015. While the rise in US crude production to a record 10.5 million barrels per day has generated market jitters, pipeline bottlenecks in US shale production have created capacity issues resulting in a $10 per barrel spread between Brent and West Texas Intermediate (WTI). The restrictions could deter the US from producing at more elevated levels if stockpiles continue to be trapped inland, but the spread makes WTI attractive relative to Brent and should continue to incentivize US exports. Indeed, international and domestic demand should both remain robust and act as a tailwind during the seasonally strong summer driving months.
Who Will Fill the Supply Void?
Returning a million barrels per day to the market would bring April’s 152% compliance rate of the OPEC-led production quota back in-line with the intended 100% level, but a large supply increase is difficult to imagine. Looking at the spare capacity of the deal participants, Saudi Arabia, Russia, the United Arab Emirates (U.A.E.), and Kuwait appear to be the only producers with meaningful capability to raise output (see Figure 3). Iraq seems unable to increase capacity due to civil unrest. Pipeline attacks and political turmoil limit opportunities to increase output in Libya and Nigeria, while Angola’s exports hit 10 year lows and they are currently producing nearly 160 thousand barrels per day below their ceiling. Geopolitical risks to supply continue to linger in Venezuela as fresh US sanctions and the recent court ruling allowing ConocoPhillips to seize $2.6 billion in Venezuelan oil assets could take the country’s output below a million barrels per day by year-end (see Figure 4). Saudi Arabia’s desire for oil prices in the mid-$80/bbl. range to raise the valuation of their upcoming Aramco initial public offering (IPO), and to balance their budget is well documented by the International Monetary Fund (IMF), leaving them less incentivized to fully turn on their taps. It may also prove difficult to convince members of the cartel that lower prices are in everyone’s best interest, especially when weighed against the immediate benefits of higher profits, particularly for countries that do not have excess production capacity.
Further, the impact of reduced capital expenditures (capex) in global oil production during years of lower oil prices is starting to be felt. Capex in global oil production companies fell from all-time highs of approximately $520 billion in 2014 to $200 billion in 2016 during the commodities mini-cycle, according to McKinsey. While oil production companies plan to increase capex between 3-5% in 2018, the effects of 15-20% declines in spending each of the past three years is evident, and a more structural pullback from maximum production capacity than a production cut could be observed.
Although there are plenty of fundamental and geopolitical variables in play, price direction will continue to be determined by the supply side for 2018. With the global supply glut eliminated, OPEC could either maintain the current supply cuts or gradually increase supply over the second half of the year, despite pressures from the Trump administration. We remain constructive on oil and energy related equities as the energy sector continues to climb higher in our sector model rankings. Historically oil prices and energy equities have been highly correlated, but this relationship has broken down, leaving room for equities to gain ground on the commodity as higher oil prices should continue to boost revenues and profits for energy related equities (see Figure 5).