While the oil market has avoided the worst-case scenario in the near term, secularly tight oil markets and high volatility are the most probable outcomes over the next decade.
Oil markets were in a precarious position even before Russia invaded Ukraine. Commercial inventories — the best real-time metric of readily available oil — have been facilitating decade-long lows on both an absolute and days-of-demand basis. These conditions reflect an exceptionally tight market where demand outstrips supply and depletes excess inventory.
Global demand for transportation fuel — particularly for jets and commercial transportation — has experienced a strong rebound. Further, demand for refined oil products was much stronger during the US-European Winter of 2021 due to Russia’s limitations on natural gas sales to Europe in advance of its Ukraine invasion.
On the supply side, there has been a significant shift from the pre-pandemic environment of rapid growth in US shale output and plenty of spare capacity from members of the Organisation of Petroleum Exporting Countries (OPEC).
Today, opportunities for supply growth are more limited.
OPEC has been bringing back its capacity over the past two years to meet demand and is getting closer to its fundamental supply limits. The cartel reports that its spare capacity is approximately five million barrels per day. However, the actual level they could quickly bring online is closer to three million barrels per day (for perspective, that’s roughly the same level of spare capacity that persisted from 2003 to 2007, a period of strong oil prices).
Meanwhile, large, publicly listed North American upstream energy companies are under shareholder pressure to limit their future supply growth.
Investors are demanding management teams generate free cash flow and higher returns on capital. They’re also reluctant to invest new capital in hydrocarbon projects when the long-term trend is toward decarbonisation.
Shareholders and corporate management also have been reluctant to make significant capital investments due to the risk these longer-dated projects could become stranded assets in the future, given evolving environmental regulations and concerns.
The upshot is the global oil market finds itself in a difficult position after years of US shale output fuelling abundant supply growth. US supply growth is slowing, OPEC’s spare capacity is limited and demand remains strong, even if that absolute demand level may be quite different 20 years from now.
The sanctions resulting from Russia’s invasion of Ukraine create the possibility of additional supply shortfalls. Some countries have directly sanctioned Russian oil imports. Meanwhile, other financial sanctions and self-sanctioning by Western companies may limit Russia’s ability to deliver its five million barrels per day of seaborne crude. Hurdles include difficulty gaining tanker access/insurance, and firms abandoning projects because of reputational risks.
Longer term, the heavy sanctions, particularly those related to the innovation that western oil companies brought into Russia, are likely to lead to a persistent production decline from the world’s second largest oil producer.
Meanwhile, global secular demand for oil and refined products continues to grow, albeit slower than in years past. Rising demand from emerging markets economies and for ocean freight and air transportation will likely ensure oil demand growth for an additional 15–20 years.
In contrast, developed market economies have begun to reduce consumption because of a slow but steady transition from gas to passenger electric vehicles. In the very short term, the slowing global economy and continuing lockdowns in China are additional risks to demand.
So, from one perspective, we have a line of sight to an eventual end of the oil age. However, the very fact we can see this end somewhere over the horizon means we are set for a period of secularly tight markets, resulting in high and volatile oil prices.
With demand likely to peak over the next 20 years — and continuing shareholder demands for capital returns — companies are increasingly unwilling to invest in new oil production.
All things considered, investors should expect relatively high and highly volatile oil prices for the remainder of this decade.
Ben Abelson, senior investment analyst, American Century Investments
