March 10, 2017

A Tale of Two Oil Markets

Saudi Minister of Energy, Industry, and Mineral Resources Khalid al-Falih talks during the Atlantic Council Global Energy Forum in Abu Dhabi, United Arab Emirates, Jan. 12. (AP Photo/Kamran Jebreili)

The outlook for a sustained price recovery in 2017 in a world overflowing with oil supplies was a major topic of discussion at one of the most important industry gatherings this week in Houston. Pessimists argued that resurgent shale oil production was undermining the impact of lower output by OPEC and some key non-OPEC producers on record global oil inventories. Optimists cautioned that more time was needed for the production cuts to reach the market. The annual CERAWeek conference brings together OPEC ministers, energy industry executives, independent shale oil producers, government officials, and bankers from around the globe to hear presentations and exchange views on the outlook for the oil market.

At the same time, the International Energy Agency released its annual five-year oil market outlook at CERAWeek, with a clear message: Global oil prices may surge by the end of the decade if investment in new supplies fails to keep pace with projected robust oil demand growth. The IEA noted that while higher oil prices have encouraged shale oil producers to increase output, investments in long-term, conventional oil projects remain exceptionally low. “The demand and supply trends point to a tight global oil market, with spare production capacity in 2022 falling to a 14-year low,” the IEA cautioned.

The current near-term outlook for ample supplies, however, is overshadowing the medium-term forecast for supply shortfalls and price spikes. Oil traders and market analysts are concerned that the OPEC and non-OPEC agreement to reduce production is having the unintended consequence of sparking a sharp rebound in shale oil production. Indeed, oil prices posted their largest one-day decline in more than a year on March 8 after data was released showing U.S. oil inventories surging to record levels. U.S. West Texas Intermediate futures prices plummeted by $2.86 to $50.28 per barrel (bbl), the steepest drop since February 9, 2016. International benchmark Brent crude oil tumbled by $2.81/bbl to $53.11. Saudi Arabia’s Minister of Energy, Industry, and Mineral Resources Khalid al-Falih and Russian counterpart Alexander Novak held a press conference in Houston to reassure markets that the production agreement will lead to the expected rebalancing of markets and stabilize prices.

OPEC Ministers Descend on Texas

OPEC ministers and officials were out in force this week in Houston, but rather than a parley of opposing forces, the gathering provided an opportunity to offer an olive branch and hold constructive meetings with shale oil producers. “It’s not so much ‘us-versus-them’ any more, but a watchful but peaceful coexistence,” noted Dan Yergin, chairman of CeraWeek and vice chairman of IHS Markit, the hosts of the conference.

In an extraordinary gesture, OPEC Secretary General Mohammad Sanusi Barkindo reached out to U.S. oil producers and hosted a private dinner the night before the conference with some 20 top executives from leading shale companies. Discussions reportedly focused on the mechanics of the new production agreement between OPEC and non-OPEC producers while the independent shale producers shared their outlook for future supply trends.

In his keynote address, Falih stressed that shale oil supplies were critical to meeting future oil demand growth. However, he also cautioned in a panel discussion that the rebound in shale production has been faster than expected, which could distort the rebalancing of markets. “The green shoots are definitely here in the U.S., and maybe they are growing too fast,” Falih said, adding “I am monitoring the watering of the green shoots.”

Forecasts for shale oil production have been repeatedly revised upward over the past six months, with estimates ranging from 400,000-800,000 barrels per day (kb/d). Yergin expects “U.S. oil production, driven by shale, will rise by more than half a million barrels per day this year, and it could be well more, depending on price.”

U.S. Largest Source of New Global Oil Supplies

The new dialogue between OPEC and U.S. oil producers reflects the growing importance of the latter in the global supply outlook. U.S. production, fueled by growth in shale oil output, is poised to be the largest source of new global oil production capacity over the next five years, according to the IEA. Total U.S. production is forecast to rise by a staggering 1.65 million barrels per day (mb/d), with shale oil providing 1.4 mb/d of the increase by 2022. By contrast, production capacity for all 13 OPEC members combined is expected to rise by just 2 mb/d.

The IEA’s latest five-year oil outlook provides a broader perspective of market fundamentals in the medium term. Global oil supplies remain more than sufficient to meet projected demand over the 2016-22 period, though post-2020 the potential for a tighter market may emerge if producers fail to increase investments and greenlight new projects. Global supplies are expected to increase by 5.6 mb/d, with non-OPEC producers providing 60 percent of the increase. At the same time, robust demand growth will lead to an increased call on OPEC crude supplies, forecast to rise from 32.2 mb/d in 2016 to a peak 35.8 mb/d by 2022, an increase of 3.6 mb/d.

Non-OPEC supplies are forecast to increase by 3.3 mb/d to 60.9 mb/d in 2022, with the United States providing almost 50 percent of the increase. U.S. light tight oil output is forecast to rise by 1.4 mb/d to 5.4 mb/d over the 2016-22 period, with growth strongest in the early years before stabilizing in the absence of higher prices or further technological breakthroughs, with rising oilfield service costs also capping future growth.

Total OPEC production capacity is forecast to increase by 2 mb/d to 38 mb/d by 2022, with much of the growth expected from the lower-cost Middle East producers. Six of OPEC’s 13 members see levels unchanged or decline. Nonetheless, the projected rise in capacity is significantly higher than the 800 kb/d rise forecast in 2016, when prices were much lower and spending constrained.

Iraq is expected to provide the largest increment at 700 kb/d, or 35 percent of the total increase. Iraq’s crude capacity is forecast to increase to 5.4 mb/d by 2022 but near-term growth will be constrained until a vital water injection scheme to boost reservoir pressure is completed. Iran, Libya, and the United Arab Emirates largely account for the remaining growth in OPEC capacity over the next five years, with smaller contributions from Saudi Arabia, Kuwait, and Ecuador.

The potential for political and civil unrest pose downside risks to the outlook for Libya and Iran. Libya’s capacity is forecast to rise by 400 kb/d, to just over 1 mb/d, by the end of 2022 but continued attacks on oil infrastructure may yet again stall the recovery. Despite the lifting of nuclear-related sanctions in 2016, Iranian capacity is forecast to increase to only 4.15 mb/d by 2022 due to the ongoing delays in finalizing the new petroleum contract terms for foreign investors, IEA reported. Despite a number of memoranda of understanding inked for upstream deals, international oil companies remain reluctant to forge ahead until the outcome of the Iranian presidential election in May and the new Trump administration’s policies toward Iran are clearer.

China and India Drive Global Oil Demand

Global oil demand growth is forecast to increase 1.2 mb/d per year from 2016-22, passing the 100 mb/d threshold in 2019 and rising to almost 104 mb/d by 2022. That is a net increase of 7.3 mb/d, with demand from non-OECD countries, primarily in Asia, rising by a steep 8.5 mb/d while OECD demand contracts by 1.2 mb/d over the period. The transport and petrochemical sectors are the major drivers of growth. Non-OECD Asia demand is expected to increase 5.1 mb/d by 2022, or 900 kb/d per year. That is equivalent to around seven out of every 10 additional barrels of oil consumed globally, IEA noted. Significant expansion of vehicle fleets and further growth in petrochemical capacity far outweigh fuel-switching savings and efficiency gains.

China and India remain the main engines of oil demand growth for the 2016-22 period. Chinese demand growth is forecast at a net 1.8 mb/d by 2022, tempered in part by improvements in vehicle fuel efficiencies and structural changes in the economy that see an accelerating shift to domestic consumer demand, away from an oil-intensive, heavy manufacturing and export-driven base. Indian oil demand growth is projected at a net gain of 1.6 mb/d by 2022, led by increased transport and residential use of oil products.

The IEA’s demand forecast is underpinned by global economic growth projected at an average rate of 3.7 percent over the 2017-22 period, according to the International Monetary Fund. Gross domestic product is forecast with an accelerating trend to the end of the decade, compared to the decelerating growth from 2014-16.

More Oil Price Volatility on the Horizon?

Oil market forecasts are inherently subject to change as events unfold but they at least provide a framework to benchmark against the market forces at work. Yergin, a Pulitzer prize winner for his seminal book on the oil industry “The Prize,” aptly noted as CERAWeek got underway that this year the “forces of change are dramatically reshaping the energy industry.”

The debate over market direction is likely to continue until solid data emerges showing a market rebalancing is firmly taking hold. Equally, OPEC’s decision to pursue a market management approach with a new production agreement at the end of 2016 has changed the trajectory of oil markets and led to prices trading in a higher but stable range of around $50-56/bbl, at least for the near term. Falih emphasized in his keynote address that Saudi Arabia does not support OPEC action to alleviate “long-term structural imbalances, as opposed to addressing short-term aberrations such as financial crises, economic recessions, unforeseen supply disruptions, or the like.” The current agreement, he said, was in “keeping with Saudi Arabia’s policy of seeking a collaborative framework of production management for a restricted period of time, with the aim of accelerating rebalancing, and then allowing the free market to work.” If the rebalancing does take hold later this year, a return to more oil price volatility is likely to follow.

Diane Munro is a non-resident fellow at the Arab Gulf States Institute in Washington.