There has been quite a sell-off in oil in the last few months. First, the deal between Iran and the West made front-page headlines and sparked speculation of an imminent drop in oil prices. Brent prices dropped 2.7% immediately after news of the deal broke, both on reduced geopolitical risk as well as hopes of more Iranian crude reaching global markets.
Second, U.S. oil production continues to climb. WTI prices dropped $1.31 in early trading on November 27, on news that U.S. crude inventories unexpectedly jumped by 6.5 million barrels the previous week. Hovering around $92, WTI reached a six-month low. Latest monthly data from the EIA shows that U.S. oil production reached 7.5 million bpd in August, a 37% increased from just two years earlier, and the highest rate of production since the early 1990’s. Drillers expect those numbers to continue upwards. Pundits and politicians alike are hailing this new era of energy abundance.
Bear market ahead? Don’t count on it.
Bet on oil prices rising again in the coming months for one main reason: global spare capacity is at its lowest level in five years.
Multiple oil supply disruptions around the world have combined to bring global spare capacity to its narrowest point since the fourth quarter of 2008. In particular, conflict in Libya has cut off over 1 million barrels per day (bpd) since July 2013. Other significant outages come from Iran, Iraq, and Nigeria. The drop in production contributed to the $9 per barrel increase in Brent prices in August. In total, there is currently 3 million bpd of production not reaching global markets, the highest since at least January 2011.
Saudi Arabia is the only true player in terms of spare capacity, as just about all other countries produce flat out. With Libyan production down over the summer, Saudi Arabia ratcheted up production to levels not seen in decades, reaching an eye-popping 10 million bpd. Although Saudi data is sketchy, spare capacity is currently less than half of what it was in 2010-2011, when the world experienced price spikes from the Arab Spring. It dropped to a mere 1.6 million bpd in August, and although it has recovered a bit as summer demand in Saudi Arabia dissipated, spare capacity is lower than at any time since the financial crisis.
With slack at multi-year lows, the ability of the Saudi Princes to come to the rescue in the event of another outage is questionable at best. Remember summer of ’08? The last time spare capacity was this low, prices reached record levels.
It’s unlikely that the pressure will quickly dissolve – supply side negatives abound. Last week’s Inside Investor hit on some of these issues, and I just want to add a few.
Kurdistan is ramping up production, but violence and the lack of infrastructure will prevent Iraq from reaching its full potential. Conflict in Libya is showing no sign of abating. Ditto for Nigeria. The U.S.-Iran thaw could be temporary – both sides are far apart on key issues over Iran’s nuclear program, making it unlikely that Iranian oil ramps up anytime soon. U.S. shale is surging, but the growth rates can’t keep going. Rig counts are down, and with high initial decline rates, drillers have to continuously poke new holes in the ground just to keep production flat.
What does this all mean? It means that another unforeseen outage could send prices skyward. Less dramatic, though equally important, is long-term fundamentals. Chinese demand continues its inexorable ascent. Other than U.S. shale, oil majors are struggling to find big new supplies. And if the world economy recovers in any meaningful way, look out.
In other words, the chances of further oil price declines are slight, while the upside risk is significant. And this comes when spare capacity is already at its lowest point we’ve seen in years.
Don’t buy into the notion that U.S. shale will save the world. Don’t buy into the hype around the Iran deal. And don’t buy into the absurd hypothesis (looking at you IEA) that Iraq can double its production in the coming years.
Oil prices are bottoming out. Bet on it.