This is for adviser use only and should not be relied upon by retail investors
MARCH 2016
Oil’s equilibrium in sight
Probably the most remarkable global macroeconomic development
of 2015 was the great oil price crash. In the first few months of 2016, oil
prices went even lower to below US$30 per barrel. Although
recovering some ground in recent weeks, prices remain low on a
historical basis, with inevitable consequences for the oil industry.
This perspective looks at the key drivers of the oil price crash, and
explains why diminishing global supply amid steady demand growth
will enable progress towards market equilibrium in 2016. It examines
the likely economic and investment implications of a sustained period
of low oil prices.
A HISTORICAL PERSPECTIVE
History shows the scope for significant volatility in global oil prices. However, with a
decline of over 30% since October 2015 and about 50% since June 2015 to below
US$30 p/b recently, the severity of the most recent price slump has surprised even
seasoned observers. As recently as October 2014, the World Bank for example was
1
forecasting an average WTI oil price of $96 p/b in 2015.
The chart below shows that the three-year oil-price cycle starting in 2014 is a
contender for the weakest on record. This is also reflected in the comparison with
longer-term averages, with the current US$36 p/b WTI price around 15% lower than
the 30-year average of US$43 p/b, a third lower than the 20-year average of US$55
2
p/b and 55% lower than the 10-year average of US$79 p/b.
Chart 1. Current three-year oil price cycle vs prior cycles
260
2014-now
2008-2010
2006-2008
240
1998-2000
1988-90
1985-87
2001-2003
220
200
180
160
140
120
100
80
60
40
20
Jan
Apr
Jul
Oct
Jan
Apr
Jul
Oct
Jan
Apr
Jul
Oct
Source: Bloomberg, March 2016, Chart depicts WTI indexed to 100 for each cycle
THE SUPPLY-SIDE VIEW
Global oil prices averaged US$95 p/b from 2011 to 2014, with Brent crude averaging
an even higher US$108 p/b in this time. This encouraged strong investment in oil
production capacity, including from higher-cost oil sources such as the Canadian oil
sands. Of particular note, the sustained period of strong oil prices coincided with the
US shale energy revolution. According to EIA data,3 this was the main reason behind
a cumulative 3.9m barrel surge in US liquid fuels supply in the three years to end2015, completely dwarfing supply growth from any other region.
AT A GLANCE
The oil price crash of 2015 and early
2016 was severe on almost any
basis of comparison.
Although recovering some ground
recently, oil prices remain low on an
historic and real basis.
Given steady global oil demand
growth, the oil price crash was
largely a supply-induced event.
Notably, strong oil prices over 201114 encouraged investment and
boosted global oil supply.
The US shale oil revolution was key
as it added almost 4m b/d of supply
cumulatively over 2013-15.
Looking ahead, our base case is that
low oil prices will curtail supply,
enabling supply and demand to
reach a balance in 2016.
A quick recovery in prices ahead of
sufficient supply adjustment and
uncertainties about new Iranian
supply are risks to this view.
To put the sheer scale of the US’s cumulative 3.9m oil surge in 2013-15 period into
perspective, it is worth noting that the world’s fourth biggest oil producer, Iraq,
produced around 4.0m barrels of oil in 2015, which accounted for over 4% of total
global oil production in the year.
Chart 2. Non-OPEC crude oil and liquid fuels supply growth, 2013-15
4
3.5
The surge in US crude oil and liquid fuels
production between 2013-15, thanks largely
to the shale revolution, was of comparable
order to Iraq’s total oil output in 2015
Millions b/d
3
2.5
2015
2014
2
2013
1.5
1
0.5
0
US
Brazil
China
Kazakhstan
Source: EIA Short-Term Energy Outlook, February 2016; * Sudan figures include those for South Sudan
THE DEMAND-SIDE VIEW
Despite the sluggish global economy and slowing Chinese economic growth, global
demand for oil has held up relatively well. Fidelity energy analysts estimate that total
global demand for oil in 2015 increased at the fastest pace since 2010. Perhaps,
surprisingly, a key driver for this has been China, where oil consumption increased by
5.5% on our estimates in 2015, the second-highest growth rate since 2010. While
industrial demand for oil was relatively weak in China in 2015, this was more than offset
by strong consumer demand with, for example, strong gains in petrol consumption. On
top of this, China capitalised on low oil prices by boosting its strategic reserves, with a
100m barrel increase during the first half of 2015 alone.
The chart below shows that despite increasing oil import volumes, low oil prices have
ensured significantly lower aggregate import outlays for China. However, while Chinese
demand in the recent past has held up well, we believe it is reasonable to assume more
modest growth rates in underlying demand for the next couple of years, owing in part to
China’s economic rebalancing away from energy-intensive fixed investment. On top of
this, the pace of strategic reserves building is likely to slow somewhat compared with
2015. As such, we expect that China’s rate of oil demand growth should slow in the years
ahead. Though Chinese demand was never as critical to the oil market compared with
some other commodities (notably iron ore), the EIA estimates that China accounted for
over 40% of incremental global liquid fuel consumption growth over 2011 to 2015. But it
3
expects this to drop to an average of 22% in 2016 and 2017.
Chart 3. China monthly oil demand by volume and value
China monthly crude oil imports by volume, LHS (metric tonnes m)
25
China monthly crude oil imports by value, RHS (USDbn)
20
30
15
25
10
20
15
2011
5
0
2012
Source: China Customs, March 2016
2013
2014
2015
2016
USD bn
(metric tonnes m)
35
WHERE NEXT?
Along with demand growth in China, we see robust oil demand growth elsewhere as well.
The US and India made a particularly strong contribution in 2015, and for the world as a
whole, we expect another year of solid growth in 2016. Thereafter, it is likely that the rate
of growth will slow, in particular as a result of demand substitution in the transport sector.
However, in 2016, we think the global excess supply problem will be corrected owing to
the non-economic viability of many oil sources. At the forefront of the global supply
readjustment will be reduced US shale oil supply. Our bottom-up analysis of the US shale
industry, based on coverage of all the major players, and on individual well data for
almost all the basins, suggests a net 0.7-1.0m barrel reduction in US shale oil supply in
2016. We expect this to be a key driver of the first net shrinkage in global oil supply since
the crisis year of 2009, with smaller reductions from many others regions, including
China, Mexico, Ecuador and Nigeria.
Chart 4. Fidelity US shale oil output projections
2.0
Chart 5. Fidelity global inventory change projections
2.0
Shale y/y production growth (mboe/d) including NGLs
Inventory change (IEA 2000-14, FIL est. 2015-16)
1.5
mn barrels/day
1.5
mboe/day
1.0
0.5
0.0
1.0
0.5
0.0
-0.5
-0.5
-1.0
-1.0
-1.5
-1.5
-2.0
2008
2010
2012
2014
2016
2018
2020
Source: Fidelity International, March 2016. Mboe/d: millions of barrels of oil equivalent
2000 2002 2004 2006 2008 2010 2012 2014 2016
Source: Fidelity International, March 2016
Also on the supply side, a recent agreement between Saudi Arabia and Russia could also
be significant. Back in 2014, the world’s top oil producer and exporter Saudi Arabia
convinced other OPEC members to abandon their usual effort to support prices by cutting
output. The Saudis were instead keen to hurt higher-cost producers and possibly their
regional foe, Iran, too. With the former objective at least looking like it has been achieved,
in February, Saudi Arabia along with Russia, the world’s second biggest oil producer,
conditionally agreed to freeze oil production around current record levels.
With a global market characterised largely by excess supply, our base-case expectation
is that low oil prices in time will curtail global supply sufficiently for oil prices to recover.
However, this base case is subject to risks. The likely timing of supply/demand
realignment is of course key. The process is ongoing, and many industry observers think
the rebalancing process could extend well into 2017. However, our analysis suggests that
a more balanced market could be reached as soon as the second half of 2016. A major
concern in this regard would be if the oil price recovers too quickly in anticipation of
supply reductions. This is because strongly recovering prices could encourage production
from some sources to be ramped again, preventing adequate supply adjustment.
Another source of uncertainty regarding supply/demand rebalancing is the extent of
increased oil supply coming from Iran following the recent easing of international
sanctions against the country. Iran is a relatively low-cost producer and it claims it can
fairly speedily increase production by 1m b/d to supply newly re-opened markets, which is
at the upper end of consensus market expectations for a 0.5m-1m b/d increase. If Iranian
supply transpires to be much higher than expected, this could be another factor that
prevents/delays adequate global supply rebalancing with a negative effect on oil prices.
ECONOMIC IMPLICATIONS OF LOW OIL PRICES - A BRIEF OVERVIEW
Oil prices are likely to remain low compared to history for the near term. However, over
the next couple of years, we would not be surprised to see a return to the norms of the
past decade, when oil (WTI) averaged US$80 p/b. This would be well above the current
Bloomberg consensus of US$57 p/b WTI for 2017 to 2019.
A more sustained period of low oil prices would be bound to have significant economic
implications. In the broadest economic sense, lower oil prices tend to be disinflationary
and are functionally similar to a wealth transfer from oil-exporting nations to oil-importing
nations. In theory, then, big oil importers benefit from low oil prices while big exporters
lose. However, in practice it is often not so simple, as correct analysis requires an
assessment for each country of the impact of low oil prices on each of the major
components of demand (consumption, investment, government spending and net
exports).
In the case of the US for example, as shown in Chart 6, consumers have benefited from
lower gasoline and other fuel prices, but there is considerable uncertainty as to the extent
that this extra money has been saved or spent. Moreover, while the US’s net export
position has benefited (owing to reduced oil imports), this and the benefit to consumers
has been substantially offset by the collapse in energy sector investment. A further
complication has been the potential exacerbation of deflationary risk and the interplay of
this with monetary policy. In many countries, fuel items are also subject to extensive tax
and subsidy regimes, which means that crude oil price developments are not directly
transmitted to consumers or companies.
Chart 6. US gasoline prices and US consumer energy spending share
10
320
8
% of income
160
Energy spending share
(LHS)
7
6
5
80
4
3
40
2
1
0
1970
Gasoline price (RHS)
Cents per gallon (log scale)
9
20
1975
1980
1985
1990
1995
2000
2005
2010
2015
Source: US Bureau of Economic Analysis, Bloomberg, NBER, Minack Advisors, March 2016. Note energy spending share
is the % of US consumer income spent on energy goods and services.
SELECTED INVESTMENT IMPLICATIONS
While the overall macro-level impact of low oil prices can be subject to considerable
debate for some countries, the sector and stock level implications tend to be more
straightforward. Generally, areas for which oil is an input tend to benefit, while those
areas where revenues are positively correlated with the oil price tend to lose out.
Examples of low oil price sector/stock winners:
Autos – low oil prices lower production costs and support demand for motor vehicles,
particularly gas-heavy vehicles such as SUVs. Stock example: GM
Agriculture – low oil prices tend to bring down various farm operating costs, including
farm machinery, fertiliser and transport costs. Stock example: Kubota Corp
Chemicals – since crude oil can account for a significant proportion of raw material costs
in the sector, lower oil prices tend to be supportive for the operating margins of chemicals
companies. Stock example: Akzo Nobel
Airlines – with fuel typically accounting for around a third of operating costs, low oil prices
can be beneficial to airline operating margins and profits, to the extent notably that fuel
purchases have not been hedged at higher price levels. Stock example: International
Airlines Group (IAG).
Examples of low oil price sector/stock losers:
Oil exploration and production (E&P) – revenues at oil E&P companies are among the
most strongly correlated with oil prices, and low oil prices can be particularly damaging for
stocks and bonds in this sector, particularly those with relatively high break-even costs
and high leverage. Stock example: Whiting Petroleum
Energy capital goods – lower oil prices mean lower investment in E&P, which means
lower demand for energy capital goods, especially those companies most exposed to
higher cost oil sources. Stock example: Diamond Offshore Drilling
Alternative/clean energy – low oil prices effectively reduce the economic appeal of a
range of renewable/clean energy products. Stock example: Tesla Motors
REFERENCES
1.
2.
3.
World Bank Commodity Markets Outlook, October 2014
Throughout this piece, any reference to the oil price refers to the WTI price unless otherwise stated.
EIA Short-Term Energy Outlook, February 2016.
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