Oil Market Forecast: Stormy with a Chance of Upside

Slightly more than a year into the oil price collapse of 2014, and nations and companies alike continue to adjust to new economic and market realities. Even in the face of markedly lower oil prices, supply continues to outpace demand, expanding the already large global inventory overhang. The surge in U.S. unconventionals production has begun to abate, but buoyed by cost reductions, improved drilling efficiencies, and capital inflows, the rate of return for half-cycle wells still manages to keep many mid-sized companies operating in key basins. Offshore production (from investments made years earlier) continues apace and Organization of the Petroleum Exporting Countries (OPEC) volumes continue to exceed the current quota by more than a million and a half barrels per day (MM bbl/d), with further increases expected to come from Iran (post-sanctions) and possibly Iraq and Libya.

On the demand side of the ledger, the recent downgrade of global economic growth by the International Monetary Fund (IMF) and others portends that, with such an oversupply, lower prices will be with us well into 2016. And with the flattening of the forward curve, the incentive to pull barrels forward will only increase, especially for cash strapped operators. In addition, as we move toward the end of the year, decisions to withdraw from stocks may be made based on the tax treatment of inventory and whether those gains/losses will help with current tax liability rather than on market fundamentals. Further, the lapsing of higher priced hedges, asset write-downs (based both on prices and production economics), and tougher loan restructuring, as a consequence of lower prices and adjusted resource values, remain poised to complicate producers’ lives.

Despite the flagging economic performance of upstream producers, lenders have not entirely abandoned the sector. Investors’ latent appetites for risk continue to feed on the long-odds prospect of a near-term turnaround story (call it the “there must be a pony” investment thesis). As long as cautious central bankers perpetuate bargain basement interest rates, operators may benefit from debt portfolios’ need for yield. And since not all producers are subject to reserves-based-lending criteria or redeterminations this fall, the real bloodletting may be one more rollover away, perhaps second quarter 2016.

If/when some of these loans are called, “fire” sales of properties or entire companies are likely to ensue. But to the extent buyers secure these assets for below market value, a lower cost basis is likely to improve the economics of ongoing production, even as crude prices continue to bounce around between $40 and $55/bbl. Couple that with the backlog of drilled but uncompleted wells and quicker cycle times, and you have the makings for another spurt of (lagged) output—even in the face of lower prices.

Prospects for achieving an OPEC agreement to trim output volumes this December are zero to grim. With Organisation for Economic Co-operation and Development (OECD) commercial inventories approaching the 3 billion barrel mark and global consumption running at only about 96 percent of supply system capacity, support for a cut now would be an extremely tough sell. Looking ahead to later next year, were it to materialize, some combination of resurgent demand and slower supply growth (or disruptions) could actually begin to erode the enormous overhang in inventory and could pave the way for at least slightly improved prices. Geopolitical risks continue to abound, especially in some large producing areas, and market watchers have tended to downplay the scant size of spare production capacity (some 2 plus MM bbl/d in a 94 MMbbl/d market), in no small part because of the large overhang of oil in storage.

Freshman economics textbooks teach that falling prices should bring demand to higher equilibrium levels. At the peak of the 2015 summer driving season, American roads delivered almost 0.5 MM bbl/d of price-sensitive gasoline consumption relative to 2014, but recovering crude prices could reverse that dynamic. Most of the rest of global demand is much stickier and closely correlated with growth in gross domestic product. For the short run, non-OECD economies seem likely to continue doing less with less.

Wood Mackenzie has estimated that in the current price environment, some $1.5 trillion in new energy investments are at risk —with either final investment decisions being deferred/delayed or high-cost projects being cancelled outright. Experience tells us that underinvestment now eventually produces price increases in the future. For now, however, the benefits of lower prices continue to accrue to consumers in the form of $2/gallon gasoline and lower heating oil and natural gas prices, and these are likely to expand to opportunistic buyers, who can secure reserves or equity participation in projects at cheap prices and can survive long enough to see the day when demand and prices rebound.

Frank Verrastro is senior vice president and holds the James R. Schlesinger Chair in Energy and Geopolitics at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Kevin Book is a senior associate with the CSIS Energy and National Security Program.

Commentary is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).

© 2015 by the Center for Strategic and International Studies. All rights reserved.

Frank A. Verrastro
Senior Adviser (Non-resident), Energy Security and Climate Change Program
Kevin Book
Senior Adviser (Non-resident), Energy Security and Climate Change Program