Last year was volatile for the global oil markets, but short-term gyrations should not obscure the bullish bigger picture.
January 2, 2019
To read the full article from Energy Analyst Pavel Molchanov, see the Investment Strategy Quarterly publication linked below.
2018 was certainly a “round-trip” journey for the global oil markets, with West Texas Intermediate (WTI) crude prices starting the year in the low $60s per barrel (Bbl), reaching four-year record heights of $76/Bbl by early October before a turbulent descent to the low $50s by the end of November. Brent’s premium to WTI was similarly volatile. On a calendar-year basis, oil prices averaged their highest level since 2014, though there is no disputing the rough end to the year.
Commodity markets are volatile by nature, reflecting both fundamental drivers and additional factors, such as the impact of the rising U.S. dollar, which placed significant pressure on already strained oil prices. Technical/momentum trading also contributed to this intense sell-off. It is important to keep in mind that short-term prices are essentially unpredictable, so we do not encourage investors to focus on short-term volatility – whether it is taking off or on a nerve-wracking descent.
Big Picture, Bottom Line
The global oil market was undersupplied in 2017, becoming broadly balanced (demand equaling supply) in 2018. We forecast undersupply persisting in 2019 and 2020. The four-year period 2017-2020, therefore, translates into consecutive drawdowns in global petroleum inventories – a virtually unheard of string of decreases by historical standards. While many U.S. investors tend to focus on the Department of Energy’s weekly inventory reports as the only real-time data source, to get a holistic view of the oil market, it is essential to look at global metrics.
Demand and Supply
After four years (2015-2018) of demand growing above the long-term average of 1.4% per year, we envision growth slowing in 2019, and even more so in 2020. While a potential economic slowdown is among the factors here, it is not the main one. Rather, this undersupplied market must see oil prices rise in order to meaningfully curtail demand growth. As oil becomes more expensive, consumers gravitate to more fuel-efficient (or electric) vehicles, and businesses take steps to reduce fuel usage as well.
On the supply side of the ledger, there is a wide variety of “line items” to track. High profile developments include pressure on Iranian exports due to the U.S. sanctions and Venezuela’s political/ economic crisis and resulting collapse in production. These are counterbalanced by the record production in Saudi Arabia and Russia. Less headline-grabbing themes include restraint in capital allocation by larger U.S. oil producers. While the U.S. – especially the Permian Basin – should remain the world’s preeminent source of supply growth in the years ahead, there are still supply declines in several non-OPEC geographies such as China and Mexico. Additionally, the limited number of long-lead-time oil project approvals translates to the gradual diminishment of this source of supply uplift over time.
Putting everything together, we anticipate back-end-loaded oil price strength in 2019, to an average of $62/Bbl WTI and $72/Bbl Brent. For 2020, while visibility that far ahead is admittedly limited, we currently envision a cyclical peak of $93/Bbl WTI and $100/Bbl Brent. The main reason for this cyclical peak is global implementation of the International Maritime Organization (IMO) 2020 low-sulfur fuel regulations – arguably the most important yet underappreciated oil market story for the next several years. While some regulatory uncertainty remains, our estimate is that the overall impact in 2020 will effectively erase 1.5 million barrels per day, or 1.5% of global supply. Not only is our 2020 price forecast at the high end of consensus, but it is even more striking when compared to the futures curve. While we do not think that triple-digit oil prices will become the new normal, it may be necessary, at least temporarily, to squeeze demand out of the system, thus preventing even steeper inventory declines. Beyond 2020, our forecast is $75/Bbl WTI and $80/Bbl Brent – a normalized level of prices that should enable moderate demand growth (even with increasing adoption of electric vehicles) as well as a level of industry-wide capital spending that could generate the incremental supply for accommodating that demand growth.
Natural Gas: Not so Notable
In contrast to our upbeat view on the global oil market, we are much less enthused about North American natural gas. The unusually cold start to the 2018/2019 winter temporarily pushed Henry Hub gas prices above $4.00/thousand cubic units (Mcf), but such prices are emphatically not sustainable. We remain bearish relative to consensus and futures pricing. Our forecast is an average of $2.75/Mcf (down modestly year-over year) in 2019, followed by a cyclical trough of $2.25/Mcf in 2020 and a long-term normalized level of $2.50/Mcf. The backdrop for our bearishness is the U.S. gas market’s “inverse” relationship with oil prices. As higher oil prices spur growth in oil production, they also drive an increasing supply of associated gas – whether or not anyone actually wants that gas. Simply put, the better things get for oil prices, the worse the read-through for gas. Improving takeaway capacity from the Permian will only exacerbate this, along with increased access to Northeast markets from the Marcellus and Utica Shale Formations.
The supply side of the gas equation outweighs the mostly upbeat story on the demand side, led over the next three-to-four years by the ramp-up of U.S. liquefied natural gas (LNG) exports. Pipeline exports to Mexico are also a growth driver, whereas the power sector is more of a mixed picture as retirements of coal-fired power plants are disproportionately being displaced by wind and solar rather than gas. Meanwhile, the European gas market is also rather weak, with demand near 20-year lows, as wind and solar are capturing market share in the electricity mix to an even greater extent than in the U.S. Gas demand in Asia is growing, led by China, but not as much as the industry would have hoped.
U.S. Energy Policy Outlook
Since we are on the topic of commodity markets, let’s address the outlook for U.S. energy policy following the 2018 mid-term elections. At the federal level, essentially nothing is changing. The Trump administration remains in control of the regulatory agencies: the Energy and Interior departments, as well as the Environmental Protection Agency (EPA) and the Federal Energy Regulatory Commission (FERC). To the extent Congress may take up impactful energy legislation – and it rarely does – anything will have to pass the Democratic-controlled House and Republican-controlled Senate. This, of course, is a recipe for gridlock.
At the state level, there were four high-profile initiatives on the ballot – in Colorado (drilling restrictions), Washington State (carbon tax), California (reduction of fuel taxes), and Arizona (upsized renewable portfolio standard) – but all four were defeated. On the other hand, three new governors – in Illinois, Michigan, and New Mexico – are set to join the U.S. Climate Alliance, a coalition of currently 16 states that are enforcing the Paris Agreement’s decarbonization targets. While any specific regulatory changes will have to go through utility commissions, it is a safe bet that the new administrations will push to accelerate retirements of coal plants. This is more bad news for the coal industry – but bullish for renewables.
Read the full January 2019 Investment Strategy Quarterly
All expressions of opinion reflect the judgment of Raymond James & Associates, Inc., and are subject to change. There is no assurance any of the trends mentioned will continue or that any of the forecasts mentioned will occur. Economic and market conditions are subject to change. Investing involves risk including the possible loss of capital. Commodities are generally considered speculative because of the significant potential for investment loss. Investments in the energy sector are not suitable for all investors.