There is never a “dull” day in share markets these days. As global equity managers, we find ourselves focused on a number of geopolitical issues. Brexit one day, trade tensions the next, Italian budgets very recently. That’s what makes it such an exciting job!
So, let’s look at the latest issue, the resurgent oil price, that recently climbed to its highest level since 2014. How things can change! In 2016, we were worried about the oil price collapse and how all these oil companies were going bankrupt. Here we are less than three years later, and we have the opposite problem, oil is too hot.
Why is the oil price higher?
There are several factors that impact the oil price but ultimately it is changes in supply and demand. Economics 101 teaches us, when demand exceeds supply for an asset, prices tend to rise and that is what is happening in the oil markets. As you can see in the chart below, global demand the (the yellow line), of approximately 99 million b/d (barrels per day), is exceeding global supply the green line by about 500 thousand b/d as shown by the light blue bars. This shortfall has led to a tighter oil market globally resulting in higher prices. Another important factor to mention is global oil inventories, that had surged back in 2016 when oil plunged, are now back to more reasonable levels and are a lesser influence on the oil price.
Concerns over oil supply are the key driving force at the moment. The US recently restarted sanctions on Iran’s oil exports, that are due to take effect from the 4th of November 2018. This will lead to less supply from Iran, a major oil producer globally. In addition, we have seen a collapse in Venezuela’s oil output. It was hoped that these disruptions to supply would be offset by strong US shale oil output (oil from crushed rocks). However, bottlenecks such as a lack of pipelines to move the oil, have curtailed supply growth in the main Shale basin, the Permian.
President Trump has responded to the high oil price by accusing OPEC (group of oil producers led by Saudi Arabia) of manipulating the market and ripping off consumers. Trump wants OPEC, which produces about 33 million b/d (approximately 1/3 of global oil output) to raise production. It seems to have worked, with Saudi Arabia agreeing with another major producer Russia to increase output.
However, the problem is, they have very little spare production capacity. In fact, one analyst suggested that global oil spare production capacity is at a 30-year low. Therefore, if an unforeseen supply disruption were to occur, prices could surge.
Also, we must remember that an oil field’s output declines by an average of -5% to -7% per year, which is what the industry calls ‘depletion rates’. So, every year we need to find 5 to 7% more oil just to stand still. Depletion rates in US shale oil fields are more dramatic, with output declining on average -30% to -35% per year. Here lies the problem. Annual investment in oil and gas projects has collapsed since 2014. This resulted in new oil reserves discovered in 2017 to reach a record low (see chart below). These factors are tightening the market.
One measure that could alleviate supply concerns in the short term, is the potential that President Trump could release some of the US emergency oil stockpiles to reduce prices. These Strategic Petroleum Reserves of 660 million barrels of oil are stored in salt caverns for use in emergencies. With US mid-term elections just around the corner, this could be an effective election ploy by President Trump.
In 2017 and 2018 global economic growth has been strong underpinning oil demand and the oil price. In 2018, global oil demand is growing about 1.5 million b/d, much stronger than expected. China and India remain key drivers of oil demand growth together contributing nearly 50%.
Looking ahead oil experts see potential for demand growth to slow as higher oil prices tend to lead to demand destruction, with $85-$90 seen as the level where demand growth slows. Time will tell if that is the case. Also, the stronger US dollar will likely impact demand as well. For example, emerging market currencies like the Indian Rupee have been very weak against the US dollar this year making it more expensive for large oil importers like India.
Other contributors to higher oil prices recently have been financial investors and oil consumers. Big oil consumers such as airlines have been actively buying in the oil futures market trying to lock in prices, anticipating oil could rise further. Financial investors have also been active in the oil futures market, positioning for higher prices and therefore further supporting prices.
Long term issues – peak demand for oil?
There is a lot of debate now on the impact of Electric Vehicles (EVs) on oil demand. BP, the oil giant, believes global oil demand will peak in the late 2030’s as EV’s will cause a “revolution in transportation”. Most oil companies see a more gradual shift away from oil in transport. For reference, about 60% of oil is used in transportation including cars, trucks, ships and aircrafts etc.
Some forecasters including myself believe oil demand will peak much sooner due to fuel efficiency, electrification and tighter emission standards.
I am a believer in the EV revolution, but it will take time. EV’s need to be more affordable to have mass market appeal. Bloomberg estimates (chart below) by 2040 EV’s could eliminate about 8 million b/d of oil demand by 2040. If Bloomberg is right, we could be “drowning in oil” by 2040.
Also, governments in China and India are proactively dealing with issues of air pollution and climate change. EV’s are part of the solution and we have seen much faster adoption in China. Developed Market countries also see EV’s as the future. Denmark, Norway, France and the UK intend banning the sale of new gasoline and diesel cars between 2040 and 2050.
Oil markets have a history of making experts look foolish when it comes to predicting the outlook for the oil price. Remember the “peak oil supply theory” that the world would run out of oil by 2030? That was until technological breakthroughs like fracking and horizontal drilling came along. Now it’s the “peak oil demand theory”. But timing is tricky. For example, the front page of the economist in October 2003 called the end of the oil age (see below), slightly premature? In August 2017, the economist called the internal combustion engine roadkill. Will this prediction be wrong too?
Weighing up the positives and negatives, short term risks do feel to the upside for oil, but analysts do expect a more balanced market in 2019. However, there may be an unintended positive consequence of higher oil prices. If you are like me and concerned about the outlook for global warming – has anyone seen the balmy weather in my home province Southland? Then perversely, higher oil prices may be the key catalyst for governments to finally get their acts together and introduce policies that address climate change. For example, why not subsidise EV’s?