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    Global Oil Supplies Tighter Despite “Glut”

    Shawn Reynolds, Portfolio Manager
    June 13, 2017

    Too Much Energy Spent Paying Attention to U.S. Shale

    While oil prices have dropped this year (down from approximately $52 a barrel at the start of the year and stalling now at $45), we believe the headlines about a "widespread oil glut" are missing a long-term secular trend of tighter global oil supplies that are likely to support higher oil prices ahead.

    U.S. shale oil production accounts for a little over 5 million barrels per day yet seems to be the only focus of the market: What about the other 91 million barrels?1

    An inordinate amount of time is spent worrying about U.S. shale oil production, in our opinion. The reality is that the U.S. shale industry currently produces less than 5.5 million barrels (Bbl) per day (or just 5.6% of the world's daily total). What the markets should really worry about is the more than 91 million barrels per day that don't come from U.S. shale.

    Focusing on the wrong thing is not uncommon among media and some oil market pundits looking to create volatility rather than rational behavior. Markedly, in these past several months, markets seem to have overreacted (and driven oil prices down) on news of U.S. inventory levels declining less than expected and, most recently, nonsensical hopes of a longer and deeper OPEC (Organization of the Petroleum Exporting Companies) quota agreement.

    Oil Supplies Will Tighten

    We see the global oil market as much tighter than portrayed:

    • Global demand growth is remarkably healthy – especially considering the anemic global GDP growth of the last few years. Given broad expectations of improvements in global GDP, the risk is that consumption growth exceeds current consensus forecasts.
    • Non-shale production could struggle to keep up with consumption and soon may be in a multi-year structural decline because of the colossal reductions in capital spending (capex) and associated record low discovery levels.
    • The OPEC "put" is firmly in place and underpinned by a historical resolve both within OPEC and with other major non-OPEC producers (i.e., Russia). In our view, the OPEC "put" entails continued concerted OPEC actions to keep crude prices above $50/Bbl.
    • Global inventories should end up well below the 5-year average levels by the end of 1Q 2018 and even below the 10-year low if the current quota agreement were to be extended through all of 2018. This analysis assumes higher U.S. shale production and moderate demand growth.

    In the face of these realities we believe in the following statement made by Khalid A. Al-Falih, Saudi Arabia's Minister of Energy, Industry, and Mineral Resources, in his opening address at the recent OPEC meeting: "Investment flows into the upstream sector have picked up, albeit at a slower pace than required to meet forecast long-term demand." This underscores our long-held view that OPEC's efforts to increase short-term pricing is more about incentivizing capital investments sufficient to meet consumption growth rather than stemming any dramatic decline into the sub-$40/Bbl range.

    Evaluating Today's Oil Market

    According to International Energy Agency (IEA) figures (report dated May 16, 2017) and the U.S. Energy Information Administration (EIA), the estimated average of world oil supply and demand during 2016 and 2017 are as follows:

    (million barrels/day) 2016 2017 Change %
    Total Demand 96.6 97.9 1.3
    Total Supply 97.0 96.8 (0.2)
    U.S. Shale 4.9 5.5 0.6
    Non-OPEC, non-shale 52.8 52.8 -
    OPEC (incl. NGLs) 39.3 38.5 (0.8)

    Global Oil Demand Growth is Resilient

    Global oil demand growth is forecasted by the IEA at 1.3 million Bbl/day in 2017. This is in comparison to the average growth of 1.4 million Bbl/day and 1.3 million Bbl/day over the last 5 and 15 years, respectively. This resilient consumption growth has been in the face of the weak post-financial crisis GDP growth.

    Global Oil Demand
    1995 to 2018e

    Global Oil Demand Chart

    Source: EIA; Bloomberg; IMF. Data as of March 31, 2017. Not intended to be a forecast of future events, a guarantee of future results or investment advice. Current market conditions may not continue.

    Notably, the IEA (International Energy Agency) has consistently underestimated demand growth. Given expectations of a strengthening global economy and an uplift in GDP, we would suggest the risk to this demand estimate is to the upside.

    Global Oil Supplies are Declining

    There is no doubt that U.S. shale production has responded to higher prices and will likely continue to grow at a robust pace. Nevertheless, even if OPEC were to return to its record level of production at the end of the current quota agreement, supply from non-OPEC, non-shale sources would have to increase to meet average demand growth in 2018. Higher non-OPEC, non-shale supply seems unlikely given the extremely poor drilling performance over the last several years.

    The following two charts show that both oil discoveries and sanctioned projects hit new lows in 2016. The first chart shows that in 2016, the volumes of conventional oil found outside of onshore North America were at their lowest levels since 1952. The second chart shows that conventional resources sanctioned for development in 2016 fell to 4.7 billion barrels (30% lower than 2015), as the number of projects that received a final investment decision dropped to the lowest level since the 1940s according to IEA.

    Conventional Oil Discoveries Plunge to Record Low in 2016*

    Conventional Oil Discoveries Plunge to Record Low in 2016 Chart

    Source: IHS Energy. Data as of December 31, 2016. *Data excludes onshore Canada, U.S. lower-48 onshore, and U.S. shallow water.

    Conventional Oil Resources Sanctioned Hit Record Low in 2016

    Conventional Oil Resources Sanctioned Hit Record Low in 2016 Chart

    Source: IEA; Rystad. Data as of December 31, 2016.

    OPEC and Falling Inventories

    Starkly illuminating the market's fixation on the potential impact of U.S. shale output on the global supply/demand balance is the apparent disregard of the historic agreements coming out of the May 25, 2017, OPEC meeting and recent trends in both worldwide and U.S. inventory levels. Simply put, OPEC and its partner producers (such as Russia) have made it abundantly clear, as seen in the quotations below, that they will follow the path of the major central banks of the world, i.e., they will do whatever it takes to create a balanced and hopefully relatively stable oil market. We believe that this means crude prices will neither get too high nor too low.

    • Khalid A. Al-Falih, Saudia Arabia's Minister of Energy, Industry and Mineral Resources: "…I attended a meeting of the Saudi and Russian leadership at the Kremlin, during which both our nations renewed their determination to rebalance the global crude oil market in the interest of greater market stability ― and restated our commitment to doing whatever it takes, together with other like-minded producers, to attain those goals."2 May 31, 2017.
    • Alexander Novak, Russia's Energy Minister, told CNBC after the meeting that there were instruments in place to react to any situation, such as an aggressive fall in oil prices. He told CNBC when asked about the possibility of deeper cuts to production: "You know, we have the capability to react to any situation that might arise on the market. And to this end we have a technical committee working on this every month."3

    More tangibly, despite seemingly constant rhetoric to the contrary, crude oil stocks in the U.S. and at the OECD (Organisation for Economic Co-operation and Development) level have been falling for quite some time and are on a path to fall well below the 5-year average target that OPEC has identified as its target milestone for a balanced market. Additionally, if the agreement was to be extended again, for example, through all of 2018, crude inventories could fall precipitously, potentially leading to an undesirable price spike.

    OECD* Total Inventories (Days Demand) vs. WTI Crude Oil (On Inverted Axis)
    1Q 2009 – 4Q 2018e

    OECD* Total Inventories (Days Demand) vs. WTI Crude Oil (On Inverted Axis) Chart

    Source: EIA; IEA; Bloomberg; VanEck. Data as of May 31, 2017. *OECD refers to the Organisation for Economic Co-operation and Development. Not intended to be a forecast of future events, a guarantee of future results or investment advice. Current market conditions may not continue.

    Energy Equities Should Benefit from Firming Fundamentals

    Amplifying the befuddling oil market's response to firming fundamentals has been the equity market's treatment of many of the culprits of surging shale oil production. Since the trough of oil prices in February 2016, WTI prices have increased roughly 81% (from $26 to $47 a barrel), while North American oil shale/unconventional oil producers equity values have risen a meager 49%, on a cumulative basis.4 This share price performance has been in spite of the fact that many of these players have shown unprecedented improvements in well productivity and operational efficiency that has allowed them to project historically unique and compelling multi-year outlooks that entail long-term, low-risk growth. In our view, as supportive oil market fundamentals begin to be properly recognized, we believe that energy company equities will begin to appreciate in price.

    Additional VanEck Resources on Oil Markets:
    Watch May 17 video: Oil Supplies Will Tighten.
    Read March 10 post: Oil Price Drop Not Surprising, Global Demand to Provide Support.