July 26, 2016—As a follow-up to Friday’s blog post, Oil and the Dollar and the Chicken and the Egg, we wanted to provide an update regarding the underlying supply/demand fundamentals within the oil market that shape our bullish view on the prospects for the commodity.

Despite the recent decline in oil prices, we think the groundwork has been laid for a multi-year recovery. The year 2016 has been another volatile one for oil with the price declining an additional 30% out of the gate as global growth concerns crept into the market. At the lowest point in February, the commodity was down 75% from its 2014 peak, marking the worst percentage decline of any prior oil cycle. This was subsequently followed by the oil price nearly doubling to over $50/barrel as growth fears subsided and global oil production started to decline after two years of significant capital expenditures (CAPEX) cuts. Although the rally in the commodity price has faded over the past month, we remain confident that the outlook for oil is positive with higher prices in the future.

Domestic production will continue to decline

The lag effect of the massive industry CAPEX cuts cannot be understated.  At this time last year, domestic supply was near peak levels with production still increasing 10% year over year (y/y). Today, as indicated in Figure 1, U.S. Crude Production is declining 11% y/y and should maintain its downward trajectory through the end of 2016. Although a handful of oil rigs have been added over the past several weeks, they will likely have a negligible impact on total production as most domestic producers require a realized price in excess of their respective break-even oil price, which is close to $55/barrel today.

Figure 1: U.S. crude production (MBbld)

 

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Source: U.S. Energy Information Administration (EIA)

OPEC is running full out

According to the latest International Energy Agency report, OPEC production rose 400,000 barrels/day (bbl/d) to an eight-year high of 33.21 million bbl/d, as Iran works toward returning to its pre-sanctioned production level. Opportunities for incremental supply growth from OPEC are muted as the big four (Saudi Arabia, Iraq, Kuwait, and Iran) are operating close to achievable peak capacity. In aggregate, OPEC production failed to grow in 2012–2014 when the average realized oil price was in excess of $100/bbl. This in turn signifies that the U.S is now the marginal global producer, which requires a higher realized oil price in order to increase production to meet growing global demand.

U.S. inventories should begin to normalize

Much of the recent weakness in the commodity has been related to concerns that domestic oil inventories remain elevated and have not declined at the pace some had anticipated. We think the inflection point within the U.S. crude oil stocks (Figure 2) should occur at the end of the summer driving season as the current trajectory of inventory draws continues into the fall and winter months. This should result in y/y declines in commercial stocks as production cuts reduce supply requiring refiners draw down existing inventories instead of adding to them as they did in 2015.

Figure 2: Total U.S. crude oil supply (MBbld)

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Source: U.S. Energy Information Administration (EIA)

Core narrative

Oil price weakness coupled with sustained global economic growth has resulted in demand for the commodity far outpacing supply, moving the oil market back into equilibrium. We expect oil demand to remain strong as global macroeconomic conditions remain favorable. However, future supply growth will likely only occur via higher oil prices to incentivize new production with economic returns. 

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