• After more than a year of inventory destocking, prompt crude oil conditions have recently softened primarily due to a timing mismatch between an increase in Saudi Arabian production and an upcoming major decline in Iranian oil exports stemming from additional US sanctions. As such, we believe a significant increase in crude prices has become more probable in upcoming months.
  • Tracking data suggests Iranian oil exports have already seen a large drop in August and that onshore inventories have built as several countries have begun to reduce oil imports from Iran ahead of the Nov 4th US deadline.
  • Demand concerns, particularly relating to the USD and potential trade wars, have also pressured oil prices down from their recent highs. Still, we believe the magnitude of the upcoming supply shortfall provides meaningful cushion for a potential decline in global crude demand estimates.

Approximately a year ago, we wrote a piece titled “Oil: It’s Getting Tight in Here” in response to crude inventories that were in the process of being drawn down after reaching cycle-peak levels in early 2017. The primary driver of the destocking was OPEC, or more accurately OPEC+, which now includes an enlarged group of oil producing countries, most importantly Russia. The expanded cartel embarked on a policy of production cuts at the beginning of 2017 with the goal of reducing global crude inventories back to the 5-year average. Despite a delayed impact (OPEC exports actually rose in early 2017 due to a ramp in production just prior to the cuts), OPEC+ was ultimately successful in driving inventories to relatively depleted levels and lifting oil prices as a result.

Today, with leaner inventories achieved, circumstances somewhat differ. Rather than aiming to undersupply the market, OPEC+ has sought to increase crude output, acknowledging major shortfalls in key producing countries like Venezuela, as well as the risk of much lower future production from Iran. This policy shift occurred at the most recent OPEC+ June meeting, where targeted production was bumped by 1.0 million barrels/day (MMbpd). Although the realistic expectation was closer to 500-700 Mbpd since only a few countries (primarily Saudi Arabia and Russia) are thought to have any meaningful spare capacity. In particular, Saudi, who was responsible for much of the prior OPEC+ cuts, is now being relied upon to supply the vast majority of the added production.

With its new objective, Saudi’s crude output has risen meaningfully in recent months from a baseline of 10MMbpd to a recent high in July of 10.7MMbpd, according to the Energy Information Administration (EIA). The Kingdom still claims to have significant additional spare capacity and total production potential as high as 12MMbpd. However, many pundits (including us) are skeptical of such a high figure, especially as Saudi has never been able to sustain production at these elevated levels for more than a few months and since output from some of its key older oilfields is broadly thought to be in structural decline. Moreover, Saudi contests the extent of its recent production increase reported by IEA and S&P Global Platts, claiming that their July production actually fell 200,000 barrels per day to 10.3MMbpd from the prior month.

Despite disagreements regarding the recent figures from IEA and Platts, the latest ramp in Saudi production has unquestionably taken some wind out of the sails for the global oil market that was previously destocking at a rapid pace. Such softness was first seen in international markets starting in early July and has been evidenced by negative near-term time spreads in the futures markets for Brent crude oil (a condition where the front-month contract is priced below the contract price for the subsequent month). We believe this illustrates current conditions that have become relatively oversupplied compared to just a couple months ago. Then, front-month prices were higher than future prices (a scenario called backwardation), which implies a tighter present market for crude.
By early August, the recent international oil market softness began to more significantly influence US markets, as the added Saudi barrels became evidenced in the weekly US import and inventory figures reported by the US Department of Energy (DOE). Granted, the weekly DOE figures can be quite volatile and subject to large revisions. Still, a multi-week trend of higher Saudi imports, combined with earlier data suggesting a counter-seasonal build in inventories, has led many analysts to conclude that oil markets are better supplied than earlier this summer. (The delayed impact on US markets from the added production also roughly matches the normal 45-60 day shipping time from Saudi ports to the US.) In combination with concerns over macro issues that could negatively impact oil demand (e.g., stronger USD, weakening emerging market data, trade concerns), by mid-August, the spot Brent and WTI crude price had fallen 11% and 12%, respectively, from their recent highs.

Some energy bears have claimed that the latest pullback (albeit now relatively mild) marks the beginning of a more significant decline in oil prices, particularly headed into a slower demand season with fall refinery maintenance downtime. Conversely, we believe recent conditions have essentially represented a pause in the continuation of oil’s tightening process, which began in earnest last spring. To us, the late summer decline in spot crude prices due to the boost in Saudi exports in tandem with a demand-related overhang (most notably an appreciating USD) has distracted investors’ attention from the likelihood of a further major tightening in oil supply later this year.

In support of our expectation for tighter conditions in upcoming months, we note the follow points:

  1. The market view of Saudi’s production potential is likely exaggerated, while the Kingdom’s motivation for robust crude prices may be under-appreciated. We believe the potential for a major boost in OPEC’s production is severely limited given realistic estimates of its true spare capacity, particularly for Saudi Arabia. The chart below illustrates OPEC’s diminished spare capacity, which is currently estimated at 2.5MMbpd (or less than 2% of global oil demand). In our view, this figure could be exaggerated by well over 500Mpd by Saudi alone, especially if the definition of “spare capacity” was strictly defined as the ability to maintain production for an extended period (e.g., 3 months). Still, even assuming Saudi could ramp to 11.5MMbpd (the figure incorporated in the capacity estimate below), there would be minimal spare capacity left on a global picture.
    Possibly more important, we note that Saudi Arabia remains very motivated to support oil prices, as evidenced by its claims that it had not further ramped production in July as reported by the EIA and Platts. Oil revenues continue to fund the bulk of Saudi’s government, and strong prices (estimated $70-80/barrel) are needed to balance its overall budget, especially with its expanded social programs and rising military spending. Saudi was a leader in pushing for expanding oil production at the June OPEC meeting, attempting to prevent a short-term supply crunch that could lead to demand-reducing prices. Still, this should not be viewed as any change in their intentions of supporting crude prices by keeping inventories relatively low and not oversupplying the market.
  2. US production has become more constrained. Pipeline constraints in the Permian Basin, the major growth engine for US shale production, has become more apparent in recent months given the rapid growth of production from this region. As a result, the likelihood for oil to be stranded in-basin in the near-term has increased. This has led to a significant discount for crude oil priced in Midland, TX relative to the price at the primary Cushing, OK hub (the Mid-Cush differential, shown below). Importantly, we believe this differential will ultimately close and activity in the Permian will reaccelerate once the large amount of planned pipeline additions come onstream in late 2019/early 2020. In the meantime, infrastructure constraints are believed to play a mitigating role to the otherwise continued rapid growth of US shale oil production.
  3. Venezuela remains in chaos with further downside to its oil production appearing likely. Given its heightened political instability, rampant inflation, and dysfunctional oil sector (now under military control), crude production in Venezuela has dropped drastically from a 2.4 MMbpd high in October 2015 to only 1.3MMbpd last month. Unfortunately, many fear President Maduro’s latest economic plan including a jump in the minimum wage, new taxes, and an additional massive currency devaluation will further cripple the Venezuela economy. Thus, it seems unlikely to us that overall conditions in the country will reverse in the near-term, implying additional downside to oil production.
  4. Violence in Libya and Nigeria continue to make those countries inconsistent sources of supply. Both countries have been producing several hundred thousand barrels per day below their prior highs. However, the on-and-off again turmoil in both regions makes it improbable that higher production levels will be achieved and sustained in the near-term.
  5. Iranian production should drop dramatically in upcoming months as additional US sanctions begin in early November. In late June, the Trump administration gave a November 4th deadline for countries to stop importing oil from Iran or face stiff sanctions from the US. As a result, and assuming no political solutions are reached in the meantime, we believe Iranian oil production could fall back to the levels seen prior to the 2015 Iranian Nuclear Deal. This would represent a massive 1.0MMbpd decline from current production levels, roughly equaling the amount of Iranian oil now being exported to Europe, Japan, and South Korea, as well as approximating the reduction during 2010-2012 with the prior Iranian nuclear sanctions. Moreover, should China and India (the two largest Iranian importers) also curtail their imports, the impact of the new sanctions could be as much as 1.6MMbpd of Iranian oil taken off the market.

To counteract the expected Iranian decline, President Trump has announced plans to release 11 million barrels from the US Strategic Petroleum Reserve (SPR) from Oct 1 through Nov 30. This amount represents approximately one-third of the 30 million barrels he is allowed to release without Congressional approval. It also undoubtedly represents an effort to prevent a spike in consumer fuel prices ahead of the US midterm elections. Still, the magnitude of the SPR impact will likely depend on the pace of the release. The SPR could offset an 800,000 bpd decline in Iranian exports if the release is accelerated over just two weeks. We view this option as rather unlikely. Instead, if 11 million barrels is released over the suggested two-month period, it would add approximately 180,000 bpd of supply, less than 20% of the expected Iranian decline.

Preliminary August tracking data suggests a large drop in Iranian oil exports, as well as a recent spike in Iranian onshore crude storage. This implies that countries have already begun to back off their oil purchases from the country. We expect this trend to accelerate in September and October as more nations prepare for the Nov 4 deadline. Still, even with an Oct/Nov SPR release, a larger impact from the Iranian production decline should be felt later in this year when demand picks up after the fall refinery maintenance season.

Additional Factors Support the Intermediate Term Crude Outlook

An insightful question we have heard from investors is “Will energy equities will really react to a spike higher in near-term crude prices if the oil price curve remains in steep backwardation and future oil prices (e.g., 2019-2021 contracts) see little price appreciation?” Naturally, prices dated further out on the oil curve are more difficult to predict and are subject to numerous macroeconomic and industry-specific factors. Still, we note two additional important factors, in addition to those listed above, that should to promote an environment of continued tight oil supplies in the intermediate term.

  • Prior cancellations of large projects soon to have a significant impact. As shown in the chart below, deliveries of large, long-lead time projects are forecasted to fall dramatically starting in 2019. This is the result of project cancellations during the most recent downturn in oil prices. Such a decline in large project start-ups will naturally increase the call on oil coming from shorter-cycle projects, such as US shale, where spud-to-crude sales is typically three-to-six months for a greenfield production and as a short as 30-60 days for wells on existing pads. This compares to three-to-five years for most major long-lead time products. Nevertheless, despite the quick production nature of shale, its supply growth is limited by sharp decline rates and infrastructure constraints.
  • IMO 2020. The International Maritime Organization (IMO) will enforce new emission standards beginning on January 1, 2020 designed to significantly curb pollution from marine vessels. The new rule mandates low-sulfur fuel be used to power ships or that shipowners install scrubbers enabling them to use high-sulfur fuel. It has been broadly estimated that IMO 2020 alone could tighten the global crude market by 1.5MMbpd through a shift in demand to middle distillates from high sulfur fuels. As such, the new standard represents another potential source of supply squeeze for crude oil in general.

Forecasted Large Supply Decline Would Provide Cushion to Demand Risk for Oil

Unlike discussing individual supply forecasts on a country or product basis, the more nebulous factor in the analysis of a commodity typically is demand. Unfortunately, the demand for oil, or any commodity, is highly dependent on macroeconomic factors where attaining an investment edge or a unique insight tends to be rather arduous. Key recent macro concerns such as the rising USD and a trade-related economic slowdown has weighed on the sentiment for many commodities, particularly those linked heavily to emerging market demand. For example, the price of copper, where China represents roughly half the demand, fell 21% from early June to mid-August, outpacing the recent retreat in oil prices.

We believe the impact of a rising USD on the emerging market demand for oil is well worth monitoring. Since oil is priced in USDs in almost every global market, the rising value of the greenback naturally makes crude pricier for consumers in emerging markets with depreciating currencies. Thus, in countries like Brazil, Turkey, India, and Indonesia, where local currencies have lost significant relative value, the risk of oil demand destruction becomes very legitimate.

Oil demand from non-OECD countries comprises slightly more than half of total global consumption, led by China (13% of global demand), India (5%), Russia (4%), and Brazil (3%). For comparison, the US accounts for 20% of global demand. The exhibit below shows the global oil supply/demand balance as estimated by the three primary forecasting agencies: IEA (International Energy Agency), OPEC, and EIA. Similar to the demand growth in recent years, the growth in oil consumption going forward is expected to be driven primarily by emerging markets. Specifically, non-OECD countries are expected to contribute 75% of the 1.6MMbpd growth in demand for 2019 that is forecasted on average by the three agencies.

By assuming approximately the same level of production expansion as demand growth, the three agencies forecast roughly flat global oil inventory levels in 2019 after some decline for 2018 in total. We note that EIA is the only agency of the three that projects OPEC production. (It is marked as flat under the IEA and OPEC estimates, an assumption that seems quite conservative to us given the factors discussed above.) Through a straightforward analysis of the figures in the supply/demand balances below, combined with the various puts and takes regarding upcoming supply, our primary conclusion is that the magnitude of the estimated OPEC supply reduction in upcoming months would provide significant cushion to a USD-related decline in global oil demand.

As illustrated below, our base case is that OPEC production falls 600,000 barrels per day in 2019, as the Iranian decline and some additional production decline from Venezuelan and other OPEC countries outweighs any further ramp in oil output from Saudi or Russia. Under this scenario, estimated demand growth from emerging markets could be reduced by 50% with no change in estimated inventory levels.

Our more aggressive case assumes a 1.6MMbpd reduction in Iranian exports, driven by China and India. Such a decline would allow for inventories to remain constant even under a no growth environment for emerging markets oil demand. Granted, it would seem unlikely that Saudi and the rest of OPEC would still be seeking to expand production if it became apparent that demand was not growing.

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