Oil Market Recovery

Blue Quadrant Research Team
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Market Commentary

Oil Market Recovery In Site

 

The International Energy Association (IEA) has reported in its most recent monthly Oil Market Report (OMR) for February, that global oil supply declined by 180,000 barrels per day (b/d) in February to 96.5mn b/d. More notably, the IEA also said that preliminary data for February suggested that OECD commercial inventories had declined during the month, marking the first such decline in just over a year.  Furthermore, the IEA said it expected total non-OPEC supply to decline by 750,000 b/d in 2016, mainly driven by a decline of 530,000 b/d in the US market, as marginal shale producers cut back  heavily on capital investment in new drilling programs.

The IEA report provides further evidence that the oil market or energy complex may recover sooner than other sectors of the commodity complex, in particular, base metals tied more closely to fixed investment or infrastructure spending. As we have detailed in our past publications, oil is in many ways a unique commodity given the inherent natural decline in the rate of production that most if not all oil fields exhibit over time. As a specific oil field is tapped for the first time, the pressure in the field is obviously very high, but as the resource is depleted (flows out of the trapped reservoir), the pressure decreases and the rate of flow out of the field starts to taper off.

Depending on the type of field, this decline rate can vary, but for shale fields, this decline rate is very steep. The rate of production from a typical shale oil well can decline by as much as 50% in one year. Therefore, the industry has to invest an enormous amount of capital every year in order to bring new fields or resources onstream, just in order to maintain global supply at existing levels, let alone increase production. At oil prices below $50 and certainly below $40, new investment simply does not make economic sense and, as a result, the industry has reduced capital expenditures (in some cases forced as smaller players try to stay afloat) sharply over the past two years and likely to levels that are not sufficient to address the natural decline rate for all oil fields currently in production around the world.

On the negative side, total oil inventories remain high and despite the improving dynamics as reported by the IEA in February, there remains a gap between existing demand and supply. IEA estimates place global oil demand for Q1 2016 at around 94.7mn to 95mn b/d, which is still some 1.5mn b/d below current supply levels. However, Q1 2016 sees seasonally lower demand for oil and based on the IEA’s estimate for an increase in global demand of 1.2mn b/d in 2016, total demand should rise above 96mn b/d by the second-half of the year, by which time based on the current rate of decline (assuming 100,000 b/d per month), supply will also have declined to around 96mn b/d. This would suggest that the oil market could in fact rebalance well ahead of recent consensus expectations and may partly explain the recent rebound in oil prices from below the $30 mark, reached in January.

World Oil Demand

World Oil Demand

However, as the table below shows,  commercial (excluding government stockpiles) oil inventories do remain considerably above prior year levels and likely also exceeding “normalized levels” even accounting for the increase in demand over the past few years. However, factoring in the IEA’s projected demand growth for 2016, total oil demand would reach 96.7mn b/d in Q4 2016. At this level of demand, a normalized inventory level would probably amount to around 1063 mn barrels, using 11 days (2014, 2012 levels). This would suggest that crude oil inventories are some 150mn barrels above normal. Under these circumstances, demand would have to exceed supply by around 1mn b/d for roughly 6 months in order to bring inventory levels back to more what we could consider “normal”.

Oil Market Inventory Analysis

Oil Market Inventory Analysis

This would suggest that the scope for a substantial rebound in oil prices this year, back to levels say above $60, is also limited and would be premature. Nevertheless, with the market for oil likely to rebalance sooner rather than later, astute commercial buyers of crude oil would probably look to begin locking in current low prices, especially given that prices out on the curve also remain depressed and below $50 (The December 2016 contract currently trades at $43). It also should dissuade oil producers from selling forward in this environment and taken together this dynamic could on its own be sufficient to ensure that a bottom for oil may already have been reached. Given the scope for market rebalancing this year and in the event global growth  gains some traction, the risk to prices further out on the curve is firmly tilted to the upside.

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