Energy: Don't Expect a Quick Recovery for Oil Prices

Energy markets have rebounded recently, but much uncertainty remains, meaning near-term oil prices could remain ugly or deteriorate further

David Meats 30 March, 2016 | 3:33PM
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Crude oil prices are well below the levels required to encourage sufficient investment to meet global demand beyond 2017, and our mid-cycle per-barrel price outlook remains at $70 for Brent and $64 for West Texas Intermediate.

But near-term prices could remain ugly or deteriorate further. Back in February a handful of producer countries, including Saudi Arabia and Russia, agreed to freeze output at January 2016 levels to help realign supply and demand. Markets rebounded as a result, but much uncertainty remains, most notably about whether Iran's likely refusal to follow suit will derail the pact or whether actual production in these countries will match agreed-upon levels.

Upstream capital budgets in the United States have fallen sharply again this year as producers struggle to align budgets with cash flows. Reduced investment will translate to stronger output declines. This should help bring global markets back into balance as well but how quickly depends on the success of the production freeze initiative. Either way, it won't happen overnight.

Sharp curtailments in oil-directed drilling activity could also reduce U.S. natural gas production growth in the near term. But the wealth of low-cost inventory in areas such as the Marcellus and Utica still points to continued growth through the end of this decade and beyond.

Abundant supply is holding current natural gas prices low, but in the long run we anticipate relief from incremental demand from liquefied natural gas exports as well as industry. Our mid-cycle U.S. natural gas price estimate is unchanged at $4 per thousand cubic feet.

Energy investors are still grappling with the critical question: How long will it take for the oil industry to work through the current period of oversupply and rebalance itself? U.S. output is likely to decline this year due to heavily reduced capital spending.

Consequently, while global demand is expected to grow by around 1.2 million barrels a day in 2016, global supply is expected to remain fairly flat, and it won't grow in 2017 either if oil prices average less than $50 per barrel this year as expected. However, the magnitude of the current oversupply is such that global stockpiles will continue growing through mid-2017 in all but the most optimistic scenarios.

What Does that Mean for Crude Prices? 

U.S. producer commentary indicates that many will start completing backlogs of deferred wells and even adding rigs if WTI oil goes north of $45. Therefore, near-term rallies above that level probably aren't sustainable. But the likelihood of strong declines this year is also waning. We expect production outside of OPEC and the U.S. to surprise to the downside, with the recent lowered output targets from Mexico and Colombia being the start of a trend, rather than one-off events.

Therefore, we expect WTI prices to hold steady in the $35-$45 per barrel range for the next 12 to 18 months, with the caveat that the scaling back of economic forecasts in consumer countries, especially China, is a key risk that could trigger further weakness. Beyond that we anticipate a gradual rebound to the mid-cycle levels outlined above, which are consistent with long-run marginal costs.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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David Meats  is a senior equity analyst for Morningstar