Oil Markets in Supply-Demand Tug of War

The key supply-side technological development is the U.S. shale oil revolution, which commenced before 2010 and has driven U.S. oil production from below 6 million barrels per day (mbd) to over nine million mbd currently, and headed for over 10 mbd in 2018 and beyond.  What is often not appreciated is that shale oil technology is not a one-time event.  The extraction technology continues to improve every year, driving the marginal cost of the next barrel of oil produced successively lower over time. Also worth noting is that the advances in supply-side oil extraction technology have largely not impacted traditional drilling, including North Sea and OPEC production.  Indeed, the major change in the North Sea oil scene is that in the 2020s safely decommissioning depleted oil wells will be a much bigger business than drilling new ones.  From a production perspective, U.S. oil output is now three times larger than North Sea oil production and that gap is expected to continue expanding through the next decade, weakening Brent’s role as even a regional benchmark.

On the demand side, the key technological development involves the great strides being made in transportation fuel efficiency.  In its refined state, the primary job of oil is to power transportation – from automobiles to trucks, to trains to boats and planes.  Total petroleum demand in the U.S. peaked back in 2005 and was then driven lower by the Great Recession of 2008-2009.  Still, after years of steady, albeit modest, economic expansion, U.S. petroleum demand in 2016 remained more than 5% below its peak of over a decade ago.  And, even more importantly, the future of fuel efficiency is getting brighter by the day with major new investments in electric-powered vehicles.   The truly impressive gains for fuel efficiency in transportation are not likely to emerge until the 2020s, yet when they do, we would be looking at a major source of downward pressure on crude oil prices.

There are some key supply disruptions impacting oil prices in the short-run.  Venezuela’s economy has imploded and production has been sharply reduced with no sign of improvement on the horizon.  The Kurdish independence vote caused some analysts to worry that Turkey would shut off the pipeline that takes oil from the Kurdish region of Iraq to markets in Europe.  Saudi Arabia has a strong incentive to cut production to push oil prices higher in the short term in an effort to boost the Initial Public Offering (IPO) price of state-owned ARAMCO.  Indeed, with the U.S. pulling back from a world leadership role, the Saudis are now talking with Russia, and a key theme is about how to keep oil prices above $50/barrel and maybe push them towards $60.  Our perspective is that the short-term supply constraints are temporary yet they may impact markets through 2018 or until the IPO for ARAMCO is completed.  And, these temporary factors appear to widen the Brent-WTI spread.

Also a positive for oil prices is the modestly improving tone of global economic activity.  China is emerging from its leadership conference with new enthusiasm and aggressive global economic and political objectives.  Brazil’s recession is over and growth is slowly returning.  Indeed, around the world, economic confidence and growth is getting just a little bit stronger, which gives oil and other industrial commodities a nice tail wind for moving higher in their trading ranges.

Consequently, short-term supply factors and improved global economic growth are pushing oil prices higher and may even possibly expand the trading range toward $60 per barrel.  And, as is common, the next downdraft in oil prices coming from long-term technology developments may be delayed for years until the transportation efficiencies are more fully realized.  Still, when oil prices rise to the top of the trading range, the maturity curve typically displays backwardation – higher short-term prices and lower long-term prices, offering very interesting and enticing risk management opportunities.