Oil & Gas

A Glitch in the Matrix

Bottom Line: Crude oil prices have plummeted over the last month due to concerns of oversupply and deteriorating demand. We believe that crude oil prices have overshot to the downside and that supply and demand concerns are somewhat overdone; that said, it will be important for OPEC to reduce production from current levels given higher- than-expected Iranian production. The fall in oil prices could also exacerbate the coming non-OPEC supply shortfall that we foresee post-2020. We continue to recommend that investors focus on companies best positioned to weather current oil price weakness.

Key Points

Fingers Crossed. OPEC is scheduled to meet on December 6 to review its quotas and production levels. The cartel (and cooperating non-OPEC countries) have done a good job supporting crude oil prices and maintaining a relatively balanced market over the last two years. The group increased production through the fourth quarter on the assumption that U.S.-led sanctions would reduce Iranian production. The U.S. has granted more waivers to maintain Iranian exports than expected, which is contributing to oversupply concerns. While Saudi Arabia is under pressure from the U.S. to maintain higher production levels, we believe that the group will quietly reduce production from current highs.

Demand Concerns Overblown.

The market is also concerned that oil demand growth could deteriorate due to the ongoing trade dispute between the U.S. and China. While we cannot predict the outcome of negotiations between the U.S. and China, we would note that oil demand growth has averaged 1.3 million b/d over the last decade and has generally only been below that level during periods of extreme economic duress. The IMF and others are forecasting reasonable global GDP growth of 3.7% in 2019, which suggests a continuation of historical trends in oil demand growth. Moreover, global distillate prices have remained firm, an indication of continued economic growth.

Not 2014 (or 1998) Déjà Vu.

The collapse in crude oil prices over the 2014-2016 and 1998-1999 periods were driven largely by excess supply as OPEC misjudged market conditions. This translated to a significant build in global crude oil and product inventories that weighed on crude oil and petroleum product prices. We do not see a replay of this in 2019 assuming the OPEC reduces production levels in recognition of higher production from Iran. Global inventory levels are in line with historical averages and should not prove problematic given our demand assumptions.

Looming Supply Shortfall.

The drop in crude oil prices comes as oil companies are setting capital budgets for 2019. This could translate to lower spending in 2019 assuming that most companies will incorporate a conservative oil price outlook of roughly $50/bbl into their capital spending plans. More worrisome, this could exacerbate the possible supply shortfall after 2020. As we noted in our recent review of non-OPEC production through 2025, there have not been enough new projects sanctioned to deliver sufficient growth in supply over the 2020-2025 period. Accordingly, any weakness in crude oil prices in 2019 could prove to be temporary.