Like most products and services, the price of oil is a function of supply and demand. During periods of extended oversupply, the price of oil tends to fall. Conversely, when there is a shortage of oil, prices tend to rise. Over the last 20 years, advanced drilling techniques, including hydraulic fracturing of shale and horizontal wells, led to an oil boom in the U.S., which added significant supply to the oil markets. This, along with relentless pumping by Saudi Arabia, Iran and other Organization of Petroleum Exporting Countries (OPEC) nations led to an oversupply of oil and a corresponding price freefall from nearly $115/barrel to about $29/barrel between June 2014 and January 2016.
As illustrated by the oversupply of oil during this period, market-derived supply and demand are not the only factors that determine its price. Oil prices have the added influence of OPEC. OPEC’s mission is to “coordinate and unify the petroleum policies of its member countries[1] and ensure the stabilization of oil markets in order to secure an efficient, economic and regular supply of petroleum to consumers, a steady income to producers and a fair return on capital for those investing in the petroleum industry.” While its member countries only account for an estimated 43% of the world’s oil production, they hold 73% of its proven reserves[2] – allowing them to exert major influence on global oil prices. It is widely believed that OPEC created the recent supply glut in order to take the U.S. supply, which is relatively expensive to produce, offline.
The problem with flooding the market with oil for a prolonged period of time without a corresponding increase in demand was the precipitous drop in profitability for its sellers. Oil is the lifeblood of the economies of many OPEC and non-OPEC member countries. For them, $30/barrel oil is not sustainable. On November 30, 2016, OPEC’s 13 members agreed to slash production by 1.2 million barrels per day. A few days later, on December 10, 2016, 11 non-OPEC producers agreed to reduce oil output by 558,000 barrels per day, pushing the total production cut by OPEC and non-OPEC members to 1.7 million barrels per day of crude.
In addition to voluntary production cuts among both OPEC and non-OPEC producers, the low price environment led to significant cuts in capital expenditures. According to the Oil & Gas Journal, U.S. oil and gas capital expenditures were set to fall 25% in 2016 after falling 36% in 2015. Couple this with the estimates from the Energy Information Administration (EIA) showing that the world’s energy demand will grow 48% from 2012 to 2040 and the majority of this demand will be met with oil and gas. The dramatic slowdown in investment and the continued growth in global demand for energy paint an improving picture for oil and gas markets in the future.
After more than two years of an oil supply glut, according to the EIA[3], the second half of 2017 will mark a shift, with supply and demand beginning to come into balance. These are forecasts, however, so it is difficult to know with certainty whether the shift will actually happen.
Key Takeaway: It is impossible to determine how the global supply/demand relationship will move in the intermediate- to long-term. The energy space is volatile at times. Despite its uncertainty, energy is a good diversifier within an investment portfolio. Given its challenges, I believe it’s prudent to both consistently invest in the space and align with managers who have continually demonstrated their ability to successfully adapt to changing market dynamics.
[1] Member countries include: Iran, Iraq, Kuwait, Saudi Arabia, Venezuela, Qatar, Libya, the United Arab Emirates, Algeria, Nigeria, Ecuador, Gabon and Angola.
[2] https://en.wikipedia.org/wiki/OPEC
[3] A principal agency of the U.S. Federal Statistical System responsible for collecting, analyzing, and disseminating energy information to promote sound policymaking, efficient markets, and public understanding of energy and its interaction with the economy and the environment. EIA programs cover data on coal, petroleum, natural gas, electric, renewable and nuclear energy. EIA is part of the U.S. Department of Energy.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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