There's an oil super cycle, you say? Part 3
Timing mismatch between supply and demand growth leading to increased probability of crude oil prices nearing demand destruction levels in 22'
The Grand Finale: Part 3 - OPEC+ and balances
Part 1 was a look at domestic demand growth, while Part 2 was the domestic supply side of the equation. Part 3 will cover the international dynamics, their impacts on domestic crude balances, and what all of the pieces mean for crude’s likely price path in 22’.
The OPEC+ Overlords
If you’ve been in the oil and gas industry since the early 00’s, you’ve witnessed a super cycle followed by multi-year bear cycles and now another super cycle? Those bear cycles kicked off with the price war between OPEC and U.S. shale. Black Friday has a completely different meaning for oil companies and investors. WTI plunged 10% ($7.54/bbl) when Saudi Arabia (“KSA”) announced (right after Thanksgiving!) they were going to block the output cut from the broader OPEC group. Commence price war 1 on shale.
Then 2020, as 2020 did with so many things, said hold my beer and watch this. Saudi Arabia decided to initiate an all-out price war with Russia, as a rift formed in the OPEC+ group. Hiking production to record levels into a global pandemic is, well it is poorly timed to say the least. That announcement drove WTI down 24% ($10.15/bbl) in a single trading session. Commence price war 2. While not directly on shale, shale felt the pain just as much as much, or more than any other producing nation.
Now, when people say OPEC+ can ruin the oil market, just think about those two events and the trauma they caused (kind of justified!). However, we are going to show why there is a lower probability of oil flooding the market in the near future. We are not saying it will never happen again, but the conditions that allowed KSA to ramp production in 2014 and 2020 are much different today. Don’t take this analysis as a “we know exactly what OPEC+ is going to do”, but a look at the probability of various outcomes.
KSA Loves $$$$
It is no secret vast oil reserves helped build the Saudi royal family into one of the wealthiest on the planet. While that history is fascinating, our focus is the Kingdom’s fiscal position and the particular incentives around oil price. Below is a comparison of the fiscal budget as % of GDP (white bars) with Saudi Central Bank FX reserves (blue line) and Brent pricing (orange line). The before and after photos of Riyadh were made possible by the near decade of consistent fiscal surplus created by higher oil prices.
The direct impact is modeled below, where we looked at the M/M change in FX reserves vs. Brent price. Over the last 15 years, ~84% of months with Brent $75+/bbl drove positive monthly FX change for KSA. Simply put, when Brent is over $75/bbl, they are likely to build cash reserves. That sounds like a pretty strong incentive to keep oil markets above $75/bbl.
So what about these price war conditions and how is today any different that 2014 or 2020?
Pre-condition 1: Big Bank - arsenal of capital is necessary to weather low prices
This brings us to the first point of why there is a lower probability of KSA flooding the market with oil. In August 2014, FX reserves hit a peak of ~$755 bn. This was a significant buffer for domestic spending while oil prices were well below fiscal break-evens. Once the price war was said and done, FX reserves had declined to a low of $491bn in September 2017. In order to maintain neutral fiscal spending, KSA will likely need oil to remain above ~$75/bbl. The Saudi Public Investment Fund (“PIF”) is another potential source of funding for domestic investment with current AUM of ~$500bn. However, given the lofty investment goals for PIF, we view this as a limited source of domestic funding.
Pre-condition 2: Storage - elevated domestic inventories providing export growth capacity while production ramps
When you want to wage an oil price war, you need not only capital, but also significant inventories. This is in the form of both tank storage and low cost drilling, or unused spare capacity. The goal of a price war is to drop delivered cost to customers to the lowest price possible, and crush your competitors who have higher break-evens. While KSA certainly hurt the shale industry in 14’-16’, KSA did not escape unscathed. We walked through the fiscal side, but just as important is what happened to their inventories. We are taking the data from JODI at face value in this analysis. If you have qualms with that, we can discuss over drinks. Below we looked at KSA crude storage vs. the last twelve month rolling balance between production and consumption. We defined consumption as the sum of direct domestic use, refiner runs and exports. Exports represent the majority of the consumption, at ~68% of total consumption over the last twelve months. The key pivot in storage happens in 2015, near the onset of the price war.
This is where things get interesting with OPEC (we will get to the plus part shortly). When KSA initiated the price war, crude storage stood at ~325mmbbl. Their significant crude storage provided a buffer for them to ramp exports and capture market share. With inventories much lower today, this condition is very different than 2014.
Current conditions: Need MOAR production
The days of using domestic storage to meet export growth are numbered. From 14’ to 18’, KSA drew down storage but had to ramp rigs to meet continued export demand growth. Production grew from ~9.7mmbbl/d to 10.6mmbbl/d, and total rig count ramped from ~80 to over 125.
Going forward, production will need to grow to meet rebounding exports and domestic demand growth. Our base case takes Saudi back to ~7mmbbl/d in exports, which will require ~10.5mmbbl/d of production (vs. ~10.06mmbl/d currently). For KSA to implement a price war again would mean taking exports to at least ~8mmbbl/d. That scenario calls for ~11mmbbl/d of production. Rigs would have to accelerate quickly, and as we called out in Post 2, the OCTG market is likely to remain tight through early 2Q22’. The rig ramp would likely not materialize until 2H22’, or mid-2Q22’ at the earliest.
What is the state company saying? Aramco is expected to increase capex by ~6% to ~$37bn in 22’. We model a gradual increase in production to ~10.5mmbbl/d by early 2Q22’. Sustainable production increases beyond that are not likely in 1H22’, and will require pulling forward capex.
KSA’s plus 1 - Mother Russia
The reason we focus on Russia in the “plus” piece of OPEC+, is due to them representing nearly 75% of the production in this group. No offense to the rest of the plus members, but Russia is the focal point. We will table the significant geopolitical implications of potential conflict in Ukraine, and then only thing we will say is conflict = tightening markets. Europe/US has given Putin significant negotiating power with the energy flows from Russia to Europe.
Two points on Russia: spare capacity and capex.
Spare capacity - commentary from Lukoil pointing to limited spare capacity remaining as production approaches 11 mmbbl/d.
Capex - growth beyond ~11.2 to 11.5mmbbl/d will likely require an acceleration in capex. Lead times from capex to production growth have historically been ~3-4 quarters. Significant growth back to all-time high production is unlikely in 1H22’ and likely takes until at least late 3Q22’ to materialize. One thing to point out, the easy comparable periods in 2020 (due to shut-in production) drove the positive LTM production growth in 2021.
Broader OPEC picture
Historically, global balances have been a driver of increases or decreases in OPEC spare capacity (outside of the 14’ price war, which we walked through why that scenario has a lower probability in 22’).
Below we look at the trailing twelve month change in global supply/demand balance vs. the twelve month change in OPEC spare capacity (offset by 4 months).
Spare capacity is typically reduced when market balances are negative, and increased when balances are positive. Simply, when the market needs barrels they reduce the amount of spare capacity (like now). OPEC is likely to continue reducing spare capacity in line with market balances until they reach ~2.5 to 3 mmbbl/d of spare capacity remaining. At the current pace of M/M production increases, spare capacity is likely normalized by mid-summer. That takes the group’s production to ~30mmbbl/d.
Balancing act - inventories
The question we always pose, what does all of this mean for the path of oil prices? For our process, we hone in on the various supply/demand factors impacting crude storage (post 1 - demand side, post 2 - supply side). When storage is negative Y/Y, crude price is likely positive Y/Y. On the left side of the plot below, we are visualizing total OECD crude storage (blue line) vs. Y/Y storage (bars) and the twelve month Brent price return (color of bars). On the right plot, we have a cross-plot representation of the relationship between storage Y/Y and the twelve month Brent price return. Simply, when storage is negative Y/Y there is a higher likelihood price is positive Y/Y.
As always, there are nuances on the demand side and we will follow this post up with a few shorter posts looking at global demand. We highly recommend 1) signing up for our friend Viscosity Redux’s Substack and 2) reading their post on natural gas’s impact on refined product/crude demand. When we say the demand side is nuanced, you will get it when you read that post. For now, we will boil this down to GDP growth likely leads to oil consumption growth. While GDP growth is likely to slow this year, it is likely we still see growth. That absolute growth means absolute crude demand growth. The near-term demand catalyst is the reduction in Omicron cases, and associated opening of cross-border travel.
Houston, we have a problem.
To summarize the fundamental side:
Demand acceleration outpacing supply acceleration in 1H22’
Supply chain constraints for production growth in 1H22’ likely ease going into 2H22’, providing upside potential on supply in 2H22’
Resulting crude inventory balance likely remains negative during 1H22’, driving storage lower and providing a tailwind to crude prices
That looks like a pretty bullish picture to us? It is. And that is the problem. We think the supply/demand mismatch, and specifically the timing mismatch, will drive inventories much lower and prices much higher. Domestically, we are forecasting crude storage to bottom out close to 350mmbbl in August. That level of storage would be fundamentally supportive of WTI heading towards $150/bbl during summer. This is the problem. When prices run high enough, it starts to hurt demand. The longer supply additions are delayed, the more probable demand destruction becomes. What threshold does this happen? Historically, when domestic oil consumption as a % of GDP crosses the 4.5% threshold, the quarter immediately following has seen negative Q/Q oil consumption in 70% of the reported quarters. At 5%+, this number increases to 89%.
Does this mean demand destruction drives prices lower immediately? Likely not. We are forecasting crude prices to roll over during summer, but finish the year close to $100/bbl. The pace of pull-back in 2H22’ will likely depend on the pace of supply additions. If supply comes online faster, and overshoots our forecast (US exit of 12.5mmbbl/d), WTI is likely to pull-back to <$70/bbl. Additionally, incremental barrels from Venezuela and Iran represent downside risk. It is worth noting even in a low scenario, we view ~$65/bbl as a likely floor. The biggest conclusion that we drew from our analysis is the “super-cycle” will be challenged, and we think the cyclicality of crude oil will cut the super-cycle short. In our view, for crude prices to sustain ~$90/bbl+ across a multi-year duration, shale inventory depletion will need to occur first (or concomitantly). The marginal barrel from U.S. shale will need full-cycle break-evens much higher than $50-60/bbl. Inventory depletion is the biggest problem for shale’s longevity, and is one we will try to answer over the next two quarters.
The last three posts were meant to be a summary of our thoughts for the 2022 crude oil outlook. That outlook drives how we view equities and the areas with the most upside/downside. Those thoughts will be covered over the next week in a couple follow up posts. We have also included the full presentation, with much more detail around the various pieces of the forecast.
If you found this analysis helpful, please like the article, leave a comment and forward to your colleagues (or anyone interested in the energy markets)!
Disclaimer: This is not investment advice. All of the views are my own, and not representative of Donovan Ventures, LLC or Energy Founders Fund, L.P.