Structural oil price volatility, global fundamentals and supply, demand and price forecasts in 2019-2020
Structural oil price volatility in the age of shale and implications for US production
The Q4-2018 crude price meltdown marked the third price decline within 60-days since 2014, a threshold that had only been breached twice since 1987. This price volatility is rooted in two key structural factors: the deepening financialization of oil markets and the emergence of a reactive and inherently financialized source of supply in US shale production.
The financialization of oil has amplified the role of expectations in oil price formation while the surge of US shale has added a dynamic element into this process, magnifying the fundamental consequences of price over/under-shoots. The combination of the two has added a destabilizing element in oil price formation that is being compounded by a destabilized and unpredictable global political and economic environment.
Conceptually, US supply reactivity acts as a source of physical market stability by mitigating protracted over/under supply. However, three elements of the US shale system have also led it to play a destabilizing role since 2014: 1) volumetric growth swings that can upend global markets; 2) inherent dynamism vis-à-vis short-term prices changes, compounded by dramatic changes in the capital efficiency of production; and 3) a financialized industry via hedging which while dampening long-term prices can act as catalyst in a sell-off.
Detailed assessment of the global fundamentals and supply, demand and price forecasts
The steep fall in WTI prices through the last quarter of 2018 dimmed production growth expectations for the US considerably from 2018's torrid entry-to-exit pace of nearly 2 MMb/d. The question is: by how much?
The lesson of 2018 is that the US production system is highly sensitive and responsive to changes in capex, and higher oil prices transmit to more spending at the drill bit quickly. Understanding the dynamic is critically important, especially considering that we expect 2019 to be another volatile year for prices.
Our base case scenario sees a 6.5% increase in capital spending from $101.4 bn to ~$108 bn - which generates our call of 1.2 MM b/d (~12%) of entry-to-exit growth. However, the evolving "growth vs, capital discipline" debate is critical to understanding how oil prices will transmit to spending levels and ultimately production.
To gain insight into the consequences of this trend, we devised a model for the US onshore designed to show the consequences of the growth vs discipline tradeoffs for the US onshore as a whole at different prices. It showed:
- Maintenance: In 2019, ~$48 WTI will generate enough cash to fund a capital program large enough to keep production flat.
- Freefall: Sub-$45 oil prices can only be withstood for a few months or quarters before oil production starts to fall off rapidly.
- Tradeoffs: Between $50/bbl and $55/bbl (roughly the current price) the onshore faces meaningful choices. It can either grow by up to 10% or it can return cash to shareholders, but it cannot afford both.
- Surge: As oil prices rise over $55/bbl, strong growth becomes the norm, and above $65/bbl, we can expect another ~20% surge in output much like that in 2018.
This post is derived from a five-part report examining Global Oil Markets in 2019-2020.
To follow the series or request for the full reports, please see Global Oil Markets 2019-2022.
Posted on 26 February 2019
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