Market Perspectives

Oil tanks

Oil market still focused on supply/demand

08.15.2018

Oil prices have been in a sustained trend higher since the beginning of 2016. But volatility is the nature of the oil price and continued volatility is likely in the next year – especially in the price spread between U.S. shale oil and West Texas Intermediate crude oil, the U.S. benchmark. Uncertainty about supply and demand is adding volatility and remains a key issue for the oil market now.

Q: What issues are affecting oil prices now?

A: We think it has been a healthy environment for oil. For about the past 18 months, the Organization of Petroleum Exporting Countries (OPEC) basically was out of the market. It was not increasing supply, with close compliance to the agreed output reduction, and even was producing less because Venezuela’s production had dropped off steeply. In addition, there have been issues in Libya and the potential for a return of U.S. sanctions on Iran in November.

The only game in town has been the U.S. as far as growing supply. U.S. output has grown about 1.5 million barrels per day (bpd), which has been enough to supply much of the strong growth in demand. OPEC’s pause in production brought inventories back to the five-year average or lower. But in June, OPEC decided to increase output again and its members now are starting to add oil supply to the market.

The keys, however, are Saudi Arabia, Russia and maybe a few smaller countries on the margin that can supply oil. As long as those producers don’t try to flood the market in an effort to generate oil income, we think we’ll have a balanced oil market with prices above $70 per barrel for Brent crude oil, the international standard, and slightly less than that in the U.S. But there aren’t many companies and countries that are unhappy with the current oil price, which seems to be a comfortable level for both the demand and supply sides. We think that market balance may extend for the next two years.

Q: What do equity valuations indicate about current oil prices

A:We think that’s an important market factor. Over the past year, oil prices in general are up about 49% but the related equities are up 10-12%. Equities obviously have not followed the moves in oil prices. We think equity valuations now are priced for oil at about $50 per barrel. By comparison, Brent crude is at about $70 and WTI is about $67. In our view, this makes for a strong risk/reward environment for the equities.

Oil prices have taken a winding path higher during volatile market year
Chart showing oil prices have taken a winding path higher during volatile market year $
Chart Showing OIL PRICES HAVE TAKEN A WINDING PATH HIGHER DURING VOLATILE MARKET YEAR
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Q: Does OPEC's output increase mean supply will cover expected demand growth?

A: We think the market still is early in the cycle. There will be a deficit until OPEC and Russia start bringing oil back to the market. That helps the market now, but who’s going to supply the growth in crude oil demand needed in 2019, 2020 and 2021? We believe the U.S. will provide at least 75%, but it’s not clear which countries can supply the remainder.

Over the last 10 years, about 70% of the growth in supply has come from two countries: Iraq and the U.S., although Saudi Arabia and Russia both added a little to their totals. But can the U.S. continue to increase supply? We don’t think Iraq can. While we think the U.S. can increase supply, it can’t go it alone in meeting demand growth.

Demand in general has been stronger than we expected. It has increased about 1.6 million barrels per year on average in each year since 2015. Much of that is because of lower oil prices. In the prior 10 years, the growth averaged 1 million barrels per year.

We don’t think the recent dramatic growth rate is sustainable, given current conditions, but that still is likely to mean a supply shortfall. U.S. shale oil companies can produce at the current oil price, but many in the rest of the world cannot. We think a higher oil price will be needed to provide the incentive to find more oil.

Global thirst for oil likely to increase with emerging market growth

Chart Showing GLOBAL THIRST FOR OIL LIKELY TO INCREASE WITH EMERGING MARKET GROWTH

Q: Can the U.S. pipeline system support increased output?

A: Pipelines in the U.S. are getting full. Two new pipelines are under construction and expected to be in service in 2019. But it’s going to get pretty tight during the next six to 12 months and a lot of producers won’t be able to get their oil to market.

In addition, there are natural gas pipelines out of the Permian Basin. You can ship oil by truck or rail if the pipelines are full, but you can’t do that with natural gas. Rail companies are carrying more crude oil now in the U.S. than they were in 2016, which was the peak. But they are moving quickly in that direction. The challenge is to ship crude oil to the U.S. Gulf Coast to be processed and exported.

Q: What could cause a disruption in oil supply?

A: Venezuela’s production is down almost 1 million barrels over the last 12-18 months and we think it will continue to fall in the near term. Then the question is how quickly the country can begin to recover and bring that oil back to the market. The major oil companies will go back there and are likely to get good contracts for five to eight years as Venezuela pushes to increase production. But we think the supporting infrastructure in the country will be a problem. Venezuela shut down a lot of its refineries, and some were done quickly and in ways that could cause permanent damage. We therefore think it could take three to five years to rebuild that infrastructure and get production back to a material amount.

The return of sanctions on Iran also is likely to cause a supply problem, although we think that will take place somewhat slowly. There have been a wide range of estimates about the amount of oil that may continue to come from Iran and whether it will be cut off completely. There also was talk from the Trump administration that any shortfall from Iran would be offset by production increases from Saudi Arabia and Russia. Nothing is settled yet, and Saudi Arabia has simply said it will only give the world the amount of oil it needs.

The administration also recently said it would release oil from the U.S. strategic petroleum reserve. We think it’s a way to talk down the markets – it’s clear that President Donald Trump is not happy about high oil prices. He doesn’t want anything to derail current economic growth. But we believe any real impact from a reserve release would be temporary and would not be a game changer for total oil supply.

World demand for oil is about 100 million bpd and the total reserve release is forecast at 5 million to 30 million barrels. There’s no estimate of how quickly that could come onto the market. But again, we believe any impact on oil prices would be temporary.

Q: What's your oil price outlook for 2019 and 2020?

A: Let’s look at recent history. We have expected prices to move higher since the beginning of 2016, when oil was about $30 per barrel and we looked for a move to $50. Basically, the industry had not spent money on its equipment or other projects for two years. That lack of spending could have caused a problem in five years. Last year, the market needed the price at a level where companies would be comfortable producing again, and the U.S. price moved above $60.

We think the price of oil now has to move to a level that gets the rest of the world’s oil industry working again – above $70 and maybe on the way to $80 – and stay in that range. In our view, companies then will commit to putting money back to work. The oil price tends to be cyclical and this is how the industry has moved after past downturns.

There are a couple things happening in this cycle that are not typical, however. Some U.S. energy companies are showing restraint in capital expenditures because they’re generating excess cash flow at current oil prices. Many are making share repurchases and some are increasing dividends. Those are unusual actions for exploration & production companies, especially in the past 10 years.

It’s worth noting that the international oil price is above $70 per barrel but pricing in the Permian Basin is closer to $55. Until the pipeline capacity issue is resolved, companies there don’t want to put money into an already tough situation.

In addition, the rig count around the world still is near the lows of the cycle and we’re not seeing investment into a lot of these resources. We thus think the U.S. will continue to supply most of the world’s demand growth.

It’s hard for investors and the oil market to believe in the price now because of the volatility. We have not seen widespread confidence to jump back into the market and invest. We think many are getting more comfortable with current fundamentals, but it may take time for market participants in general to believe that this price level will hold.

Q: What are the risks to your current outlook?

A: We think there are several:

  • Electric vehicles: There were ideas electric vehicles would be in wide use by 2025. Now it seems that it will take a much longer time to turn the world’s fleet of cars and trucks into electric vehicles, and to build out the supporting grid and infrastructure. We don’t think that will happen by 2025. We do think electric vehicles are here to stay and will be material as time goes, but we’re far away from that time.
  • Declining oil inventory: Worldwide oil inventories are below their five-year average and we think they will continue to decline for the next few months. OPEC has begun to increase output again but at a conservative pace, in part just to keep up with demand. In the U.S., the pipeline bottlenecks are affecting supply growth. But the energy stocks still haven’t reacted yet.
  • Early in recovery stage: We’re focusing on market fundamentals now, not on “What if?” scenarios for supply and demand. We think the market still is at an early-recovery stage, which can add to uncertainty. While change is possible, we think the fundamentals of supply and demand mean the market is pricing correctly now, but change certainly is possible.
  • Changes to supply/demand: The market for about the past two years has seen oil demand at a rate above its historical average. We think it’s reasonable to assume there will be a reversion to the mean in demand, in part given higher prices. If there is a major change in demand from China or a surprise increase in supply from Venezuela or Libya, that would shock the markets. There’s also the potential that the new U.S. pipelines due in late 2019 could prompt producers to begin a major re-acceleration in supply growth. That growth coupled with demand returning to average could add balance to the market.
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key takeaways

  • U.S. output is up about 1.5 million barrels per day, enough to cover strong growth in demand.
  • Pipeline capacity will be limited in the next 6-12 months, restricting oil from the Permian Basin.
  • We think oil must move to $70-$80 and stay in that range to get the global industry working again.

Investment strategy

investment team

David P. Ginther, CPA

Senior Vice President, Portfolio Manager

Mr. Ginther is co-portfolio manager of the firm’s Energy investment strategy and has served as a portfolio manager of the strategy since 2006. He has been portfolio manager of the firm’s Natural Resources funds since 2013. He was portfolio manager of the firm’s Dividend Opportunities funds from 2003 to 2013. He joined the firm in 1995 as an equity investment analyst, covering industries in the energy, materials and utilities sectors.

Mr. Ginther had previously been a senior business analyst with Amoco Corporation. He began his career with Amoco in 1986. He experienced a variety of opportunities while at Amoco related to exploration and international financial reporting.

Mr. Ginther earned a BS in Accounting from Kansas State University and also earned a Certified Public Accountant designation.

Michael T. Wolverton, CFA

Vice President, Portfolio Manager

Mr. Wolverton is co-portfolio manager of the firm’s Energy and Natural Resources investment strategies, appointed to this role in 2016. He had served as assistant portfolio manager to the strategies since 2013. He is also a member of the firm’s equity research team, covering energy equipment and services, and oil, gas and consumable fuels.

Prior to joining the organization in 2005 as an equity investment analyst, Mr. Wolverton held an intern position at the firm in summer 2004.

Mr. Wolverton earned an MBA with an emphasis in Finance from the University of Texas at Austin, McCombs School of Business and a BS in Accounting from William Jewell College.

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