Oil: The Black Gold

Matthew Seaward
February 27, 2018

The price of oil is often discussed in generic terms, however, it is important to realise that there are many types of oil; ranging from Brent light sweet to Arabian heavy. This, in conjunction with the assets location and delivery type, gives oil its intrinsic value. Due to this, a benchmark price is typically used - Brent Crude and West Texas Intermediate being the pre-eminent global benchmarks. Oil consumption is synonymous with global trade and industry and is resultantly used as a key economic indicator due to this perceived price linkage. Given changing dynamics in the global demand and supply picture, is this trend set to continue?

It is sometimes difficult to derive the complete reasons behind the price moves of oil since it represents a financial asset as much as an industrial good. One micro-economic theory in the field of commodities is ‘mean reversion’. This specific theory puts forward that high prices will increase supply due to new market entrants. This puts downward pressure on prices, forcing the market to return to equilibrium. Conversely, if prices are relatively low, some producers will not be able to enter the market, which in consequence reduces supply. This theory has a lot of grounding to it from academic research- a 2015 Reuters article hinting at the ability of US shale producers to adjust production according to prevailing market conditions appears to hold true today, and the emergence of the US as a significant marginal producer may hinder significant increases in the oil price from current levels.

With unconventional resources such as shale oil having a much smaller implementation cycle, this has enabled ever-shortening response times to changes in supply and demand. Technology has also allowed producers to cut their cost of production over the year; something that Saudi Arabia seemingly miscalculated when it tried to put US shale producers under pressure by maintaining production levels despite this rapidly growing supply source.

The US Energy Information Administration (EIA) forecasts that annual US production will increase from 9.33 million barrels per day in 2017, to 10.6m b/d in 2018, and to 11.2m b/d in 2019. This is staggering when compared to the 2008 production levels of approximately 5m b/d. An increase to over 10m b/d would see the US exceed its previous highest annual production figures set in the 1970’s, and leapfrog over Saudi Arabia and Russia to become the world’s largest producer.

One feature of the oil market that is uncommon is precautionary demand, which reflects the expectations and concerns about the future need for oil. In addition to normal usage, oil is considered a national strategic resource with countries building up significant stockpiles as a result. This tends to lead to prices responding rather quickly to any announcements regarding inventory scarcity. One theory suggests that these inventories act as a buffer to price movements, almost like cash on the balance sheet. If such theory holds true then higher inventories should lead to lower volatility in the prices of oil.

Although OPEC is still the price-setter and market leader in optimising profits, the US in the future will exert more control over the marketplace, especially when it invests further in its exporting capabilities after the lifting of a long-standing export ban. Given these structural changes in the oil market, we have taken a house view that $70 a barrel represents a price ceiling in the short-term. However, major oil companies have been experiencing rising profitability after many years of cost cutting and are able to comfortably prosper at the prevailing price with further capital discipline.

The graph below has been compiled using data from the recent BP Energy Outlook. It represents the expected consumption and production of oil historically and over the next 20 years. Expectations are that an extra 9m barrels will be needed daily in 2040, even with the rise of electric vehicles:

While oil demand is predicted to decline in OECD countries, non-OECD countries are expected to increase consumption of oil by around 40% over the next 20 years. However, although consumption is expected to rise, its share of the global energy mix is expected to fall from around 32% to 27% by 2040. Over the next 20 years, the energy market as a whole is expected to become increasingly competitive with oil, gas, coal and non-fossil, all making up approximately one-quarter of the market each by the end of this period.

By 2040, it is expected that 30% of passenger cars will be electric-powered, as well as traditional combustion engines also becoming considerably more energy-efficient. In the EU, cars are likely to be 70% more efficient than they were in 2000.

However, these efficiency gains will be offset by a substantial increase in the number of vehicles in developing countries, as well as an increase in commerce globally; with both trucking and air passenger travel expected to be particularly strong. Even if the adoption of electric cars were much more aggressive than in this scenario, investment in new oil assets would still be necessary with a limited impact on total oil demand.

Increasing prosperity globally will lead to a growth in energy demand. Therefore, whilst in the very long-term oil will no longer be as relevant as it currently is, in the short-term it remains an absolutely vital resource.

Disclaimer: The views thoughts and opinions expressed within this article are those of the author, and not those of any company within the Capital International Group (CIG) and as such are neither given nor endorsed by CIG. Information in this article does not constitute investment advice or an offer or an invitation by or on behalf of any company within the Capital International Group of companies to buy or sell any product or security.

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