In the past, we’ve only seen the type of surplus the IEA is predicting during extreme events such as the global financial crisis or the Covid-19 pandemic. Such events usually catch the market off-guard, with demand weakening suddenly, leaving supply unable to respond quickly.
In contrast, the current glut is well publicised, which makes it more likely that supply will respond before the actual surpluses are realised. However, to incentivise this response, we probably need to see prices lower than they are today – geopolitical risks in the Middle East and Ukraine are keeping prices higher than they would be otherwise.
HOW DID WE GET HERE?
It’s hard to believe that just a few years ago, observers were concerned about energy (and oil) shortages in the aftermath of Russia’s invasion of Ukraine. In the years before this, we saw European oil majors scaling back significantly on their oil investment plans as the world was expected to go green rapidly. The war changed everything, with energy security again being top of mind, leading to many of these commitments being cancelled as oil prices rocketed to nearly US$130 per barrel.
In addition to the increased supply, we also saw demand coming in weaker in 2024 than was expected at the start of the year. China played a major role in this lower-than-expected demand as the country continues to battle sluggish growth.
WHAT ABOUT OPEC?
The Organization for Petroleum Exporters (OPEC) has been in a strong position in recent years, with low spare capacity in 2022 giving member countries the ability to offset the demand weakness seen throughout 2023 by cutting back production to keep prices higher. However, their spare capacity levels have now risen to multidecade highs (excluding the Covid-19 period), making it more difficult to negotiate additional cuts from the current base. However, as evidenced at the recent OPEC+ meeting, we do think it likely that OPEC will keep current cuts in place for longer, which should help avoid at least a part of the expected surplus.
HOW LOW CAN PRICES GO?
Under normal economic circumstances, oil demand is relatively inelastic to prices – small changes in supply can therefore have a large impact on prices. Unless there’s a recession or any other significant oil market event, we wouldn’t be surprised to see prices fall below the US$60 per barrel level, should forecasters be correct in their estimates of surpluses. However, we wouldn’t expect prices to stay there for too long given the responsiveness of the US shale industry. With most of the production from a shale well being delivered in the first year of operation, decisions to stop drilling wells can have a rapid impact on supply.
The US shale industry produces just over 10 million barrels per day or 10% of global supply. Given technological breakthroughs, the average break-even price per well has declined from more than US$80 per barrel in 2015 to around US$50 per barrel today, which makes US output very competitive in the current environment. However, the distributions of project break-evens are quite wide, and we estimate that ~20% of wells will fail to make money at oil prices below US$70 per barrel. This equates to ~2% of global supply that can respond quickly if prices do correct.
MEDIUM-TERM OUTLOOK
As we’ve argued before, we anticipate that oil demand will continue to grow for longer than many expect, with a peak unlikely over the next decade. Emerging markets will continue to experience population growth, requiring more energy to fuel their economies. The World Bank has estimated that there will be roughly 9.7 billion people by 2050 compared to 8 billion today, with most of this growth taking place in India and Africa where energy usage per capita is very low.
Alternative fuels (for electric and hydrogen vehicles) do pose a significant long-term threat to oil demand (passenger cars currently make up roughly 25% of all oil demand and commercial vehicles another 15%), and electric cars’ share of new vehicle sales is rapidly increasing (especially in China, where the share of new vehicle sales has now reached ~50%). However, it will take time for these vehicles to penetrate the global car park of ~1.4 billion vehicles – most of which are still fitted with a petrol or diesel internal combustion engine.
From a production perspective, our research points to there being enough potential projects available over the medium term, leading to a well-supplied market. We therefore see prices of more than US$90 per barrel as unlikely, unless a significant geopolitical event disrupts supply.
However, we’ve also seen that major producers have become more disciplined, only initiating projects that generate adequate returns at much lower oil prices than today. This, along with US shale production finally beginning to plateau and important OPEC countries with fiscal break-evens of more than US$70 per barrel, informs our view that prices in the US$70 to US$80 per barrel range is a reasonable level over the medium term.
OIL COMPANIES IN OUR PORTFOLIOS
Considering recent market developments, we have been scaling back our investments in oil companies across our portfolios as we see the risk-to-reward ratio as being more skewed to the downside in the near term. However, given the unpredictable geopolitical landscape in both the Middle East and Ukraine, we think it is prudent to retain some exposure in our portfolios as a hedge against a major unforeseen event.
