Itaú BBA - Oil: Adjustment by mid-2016

Macro Vision

< Back

Oil: Adjustment by mid-2016

March 18, 2016

We forecast crude oil prices at USD 55/bbl by year-end, with the end of global excess supply.

Oil prices fell below USD 30 per barrel in early 2016, raising concerns about the financial health of a number of companies and countries.

In February, oil prices recovered to around USD 35/barrel, partly due to expectations of an agreement between OPEC and Russia. We do not expect any such agreement to materialize. In our view, OPEC-Russia coordination will not be the adjustment in the oil sector that leads to a recovery in prices.

Looking beyond the price volatility, we would highlight that the oil industry has been adjusting to the oversupply. Most notably, investment in shale oil in the U.S. has plunged, and onshore production declined from 8.24 million barrels per day (mbd) in May 2015 to 7.63 mbd in December 2015.

We expect the state of oversupply to end in mid-2016 (moving from a surplus of 2.2 mbd in 4Q15 to a deficit of 0.2 mbd in 3Q16).

The main elements of this transition are: i) a drop in U.S. production from 9.2 to 8.7 mbd; ii) a 0.5 mbd increase in Iran exports as a consequence of the end of sanctions; iii) Saudi Arabia maintaining production at 10.2 mbd; iv) other OPEC countries (excluding Iran and Saudi Arabia) maintaining constant production levels; v) the rest of the world reducing production by 0.6 mbd (to 44.3 mbd), with maintenance in Europe and some production declines elsewhere in reaction to lower prices; and vi) global demand rising from 95.1 mbd to 96.9 mbd (consistent with global GDP growth of 3.2%).[1]

In this scenario, we expect oil prices to recover to USD 55/barrel by year-end 2016.

The risks to this scenario are mainly downward. In our view, the main risks are: i) weaker global demand; ii) a slower decline of shale oil production in the U.S.; and iii) a new round of production increases by OPEC (excluding Iran). In contrast, the possibility of an eventual OPEC agreement to reduce production represents an upward risk for oil prices. However, we believe that such an agreement is unlikely.

In this report, we describe the causes of the current oversupply, analyze our supply and demand forecasts, and justify our outlook for price reactions. A table at the end of the report shows a breakdown of our supply and demand projections.

What caused the current oversupply in the oil market?

The current surplus in the oil market is the result of an abnormal increase in global supply. In 2013 and 2014 a non-conventional production boom in the U.S. boosted global supply by 1.0 mbd and 1.1 mbd, respectively. In 2013, OPEC reduced production to accommodate this increase. In 2014, the cartel changed its strategy and increased production, triggering a jump in global supply (see Chart 1). In 2015, OPEC production continued to increase, while U.S. production growth lost momentum (but still surprised on the upside).

Between 2010 and 2015, contrary to the perception of a global demand slowdown, demand continued to rise at the average pace it has sustained since the normalization that followed the 2008-09 crisis (Chart 1).

Demand growth expected to maintain steady pace 

Global demand grew at an average rate of 1.1 mbd per year between 2010 and 2015 (Chart 1), with the growth concentrated in emerging markets. While demand in OECD countries decreased by 0.9 mbd in the period, the cumulative demand increase in emerging-market economies over this period was 6.6 mbd. Despite the recent developments, demand is still well distributed between developed (49%) and emerging markets (51%). Therefore, the performance of developed markets is still important for global demand (both because of the indirect effect on emerging markets and because of direct demand).

China is important for global oil demand, but not as important as it is for metal commodities. China accounts for 11.8% of global oil demand – a lower share than that of the U.S. (20.5%) – and was responsible for 37% of the demand increase between 2010 and 2015. These numbers are significant, but less impressive than the comparable figures for metal commodities, for which China absorbs 50% of global demand and has accounted for nearly all the demand increase observed in recent years.

For the coming years, we expect global demand to continue to rise (growth rate of around 1.3% per year). Oil demand is well explained by a model that takes into account global GDP (Chart 2) and price variation over the previous two years. This model explains 63% of the variation in demand growth over the past 17 years.

We forecast a 1.5 mbd increase in 2016. Given our base-case scenario of 3.2% global growth in 2016 (compared with 3.1% in 2015) and the sharp drop in prices seen in 2014 and 2015 (-46% and -32%, respectively), the same model forecasts a demand increase of 2.2 mbd in 2016. However, the model extrapolates a price elasticity corresponding to a larger shock than any of those observed in the past period of the sample, and it does not take into account several adjustments that limit the demand reaction to lower prices. For example, several oil producers have been raising domestic gasoline prices as part of a fiscal adjustment to offset declining revenue from oil production. Therefore, we consider it appropriate to reduce the growth rate signaled by the model by 0.7 mbd, to 1.5 mbd.

The risk of changes in the demand pattern remains low. Among economic sectors, the biggest single user of oil is transportation (63.8%),[2] followed by product manufacturing (16.2%) and industrial energy supply (8.4%). Other sectors (agriculture, residential heating, etc.) together account for 11.6% of consumption. Technological advances that allow for a broad replacement of oil in transportation are still some years away. Coal had been replacing oil in energy generation (excluding transportation), but coal use is being hurt by the boom in natural gas production, given the comparative advantage of the latter as a source of energy for non-transportation purposes. Similarly, the high demand for oil for use in transportation and the production of goods is constraining the impact of an ongoing growth rebalancing in China (less investment, more consumption; away from industry, toward services).

Global supply will likely recede in 2016, even with an increase in supply from Iran

The global production outlook can be broken down into five factors: i) the U.S. reducing unconventional production; ii) an increase in exports from Iran following the end of sanctions; iii) Saudi Arabia adhering to agreements to stabilize supply; iv) other OPEC members maintaining constant production levels; and v) a slight decline in production in the rest of the world.

Oil-price declines first affect investment, then production. Prices below USD 70/bbl are already affecting new projects (some have total cost levels of around USD 100/bbl), but the marginal cost of ongoing production is below USD 20/bbl, so producers have been maintaining production from current wells even with oil prices near USD 30/bbl.

Several indicators point to a reduction in investments since year-end 2014: a sharp drop in the number of oil rigs in exploration activities, a decline in gross fixed capital formation in oil-producing countries, and reduced capex disbursements by listed companies around the world.

The reduction in shale oil investments in the U.S. is already affecting production, and this effect will intensify in 2016. The number of oil rigs employed in the creation and expansion of wells (the rig count) in the U.S. fell from 1,592 at the end of 3Q14 to 628 at the end of 2Q15. By early 2016 the rig count had dropped to 400 (see Chart 2), reflecting the fact that oil prices are now below breakeven with total production costs at several exploration fields in the country. Our U.S. production model, which is based on the rig count observed over the previous four years, now forecasts a year-over-year drop of 0.5 mbd in 4Q16.

In fact, onshore production in the U.S. started falling in April 2015, about nine months after the rig count started to drop (Chart 3). Still-rising offshore production (which has a longer investment cycle, with a greater lag between investment and production) offset the beginning of this transition.

We forecast an increase of 0.6 mbd in oil exports from Iran between December 2015 and June 2016. This scenario is close to market consensus estimates of the impact of the end of the Iran sanctions, which range from an increase in exports of only 0.25 mbd (taking into account the possibility of a significant amount of idle capacity in the country after years of underinvestment) to an increase of up to 1 mbd. Talk of Iran potentially signing on to an agreement to limit global supply has been affecting prices in the short term, but this is an unlikely scenario.

Our scenario for Saudi Arabia and the rest of OPEC is that supply will remain stable at the (high) levels observed in 4Q15. This scenario rests on two underlying assumptions: i) an interruption in Iraqi production growth due to the lagging effects of the conflict with ISIS; and ii) the main Arab countries’ sticking to their strategy of forcing the rest of the world to reduce investments (and production) until a new market equilibrium is reached.

The recent agreement to freeze production reached by Saudi Arabia and Russia (and to be joined by Qatar and Venezuela) reinforces our baseline scenario for OPEC (excluding Iran).

For the rest of the world, we expect some decline in production primarily associated with maintenance work and decay in existing wells (the impact of lower investment will come later). Investment indicators (GDP breakdowns, company balance sheets) also point to a drop in production in these countries, but the lag between investment and production pushes the effect of adjustments on production toward the end of this decade. We forecast an average production level of 44.3 mbd in 4Q16, compared with 45.0 mbd in 4Q15, with the decline mainly caused by above-normal maintenance work on North Sea platforms and reduced output in the Americas (excluding the U.S.).

A transition in the global balance will likely lead to higher prices in mid-2016

Historical data since 1998 suggest that the recovery in oil prices will occur in the quarter in which the seasonally adjusted balance moves from surplus to deficit. Table 1 lists the most recent minimum cyclical oil prices (WTI and Brent average) and the quarter in which the market moved from surplus to deficit. Econometric models also suggest that the balance (supply minus seasonally adjusted demand, divided by demand) is most relevant in the same quarter.

Thus, the transition from global surplus to global deficit that we forecast for 3Q16 (see Chart 4) would be consistent with prices at minimum levels throughout 2Q16. Even though the forecasted deficit is small (0.2 mbd, or 0.2% of the seasonally adjusted demand), the fact that it stems from an adjustment in supply that will intensify in the following quarters makes it reasonable to expect that the recovery would start from this point. This “anticipation” by agents seems to offset the fact that inventories are at high levels when prices reach their historical lows. Econometric models support this hypothesis, indicating that adjusted inventory levels are not statistically significant in explaining the variation in prices.

The biggest risk is a postponed transition to equilibrium 

The two main risks to our baseline scenario – i) lower demand and/or ii) a slower production adjustment in the U.S. – threaten a slower transition to either equilibrium or deficit.

Demand could be weaker than we assume due to lower global growth or a weaker-than-expected reaction to low prices in oil-producing countries. The second risk factor reflects the possibility that these countries could attempt to reestablish their macroeconomic equilibrium (lost as a result of the drop in international oil prices) by reducing their subsidies of domestic gasoline prices. In this case, some of the demand for oil (especially from Saudi Arabia, Venezuela and Russia) could be influenced by a price effect working in the opposite direction from the market signal.

The risk of a slower adjustment in the U.S. reflects the uncertain timing of the expected reaction to lower prices. The shale oil cycle is still quite recent (it started in 2009), and a full cycle of investment reductions followed by lower production has not yet been observed.

OPEC is a source of risk in any supply-and-demand scenario for oil, but we believe that the current circumstances favor our baseline scenario. The disincentives to cooperation among the OPEC nations, which are now being exacerbated by the geopolitical conflict between Saudi Arabia and Iran, lower the risk of a coordinated production cut. In addition, the agreement between Saudi Arabia and Russia (to be joined by Qatar and Venezuela) lowers the likelihood of a new round of production increases.


Artur Manoel Passos

[1] Supply numbers by region include some seasonality. The aggregated demand and supply series are seasonally adjusted. Variation between 4Q16 and 4Q15.

[2] Oil-use figures obtained from the International Energy Agency report “2015 Key World Energy Statistics”.


< Back