Conditions Right For Oil Market Rally Post 2020

It’s hard to imagine a spike in oil prices in the current market where prices have been stuck at around $60 a barrel for many months. 

Oil hasn’t been able to sustain a rally, even after the devastating attacks on Saudi oil infrastructure on September 14 that temporarily knocked off more than half of the kingdom’s production.

But investors would be wise to remember that oil is a cyclical commodity. It won’t stay lodged at recent levels forever. And if you look closely, it’s not hard to see how oil prices could rally substantially in over the next two to five years. 

What could spur a price push toward $80? For starters, a resolution to the US-China trade war would go a long way to improving sentiment in markets. The Trump administration’s tentative “phase one” trade agreement with China in October is an excellent first step, but much work needs to be done to complete a comprehensive deal. Good news on US-China trade helped move the international benchmark oil price past $64 in late November and drive U.S. equities to new record highs before both markets pulled back in recent days.

A trade deal would also alleviate concerns about future oil demand that have held back crude for some time now. There’s likely no stopping the “hefty supply cushion” that is likely to build up during the first half of 2020, as the International Energy Agency (IEA) states in its most recent report, due to rising non-OPEC supplies.  

IEA forecasts non-OPEC supply will add a massive 2.3 million barrels a day in 2020, with the growth coming from production in the United States, Brazil, Canada, Norway and Guyana. That will more than cover anticipated increases in global oil demand of 1.2 million barrels a day and force OPEC and some non-OPEC partners, led by Russia, to continue price-supportive supply cuts. Even deeper reductions are possible when OPEC meets Friday in Vienna, though OPEC representatives are signaling that the status quo will hold. 

The outlook for 2020 does not look great. Oil prices could fall even further before seeing any meaningful recovery unless OPEC deepens its cuts. 

It’s the 2021-2025 timeframe where things could get more interesting. Experts generally agree that growth in U.S. shale oil production is now slowing. New shale supplies have single-handedly been satisfying the increase in global oil demand over the past two years, but that trend could be in jeopardy starting as early as next year. 

The pace of the shale slowdown is a critical determinant in global oil market activity in the coming year, but opinions vary widely on the subject. 

The U.S. Energy Information Administration (EIA) still expects domestic crude production to increase by 1 million barrels a day in 2020. That is almost enough growth to cover the expected increase in global demand. 

But some independent observers believe EIA’s projections are too bullish considering the sharp drop in drilling activity and capital discipline seen in the U.S. oil industry this year. Many shale producers continue to have a difficult time breaking even under today’s oil prices, and investors are fed up with capital destruction in the sector and aren’t providing the hefty credit lines of past boom years. 

Meanwhile, the large inventory of drilled but uncompleted wells (DUCs) is depleting fast. To date, U.S. producers have been able to maintain healthy production growth rates despite utilizing fewer drilling rigs by completing their reserves of DUCs. But that may soon change. Analysts at Raymond James warn that DUCs could reach critically low levels as early as February, meaning fewer quick well completions and less new oil flowing to market. 

The consultancy IHS Markit now sees total U.S. production growth dropping to 440,000 barrels a day in 2020 before essentially flattening out in 2021 at a price of $50 a barrel. Such a scenario would be a gamechanger for global oil prices. 

That’s because investment in conventional oil projects, including offshore, oil sands and Arctic plays, has been lagging since the price collapse of 2014. Big oil companies never fully resumed their appetite for expensive “megaprojects” that take years to pay off. In part, that’s because of lower oil prices but also because shale offered a quicker return on investment. Shareholders have also been demanding higher dividends and stock buybacks, which have constrained the capital budget plans of the oil companies. 

Goldman Sachs now expects non-Opec production growth to stop as early as 2021 at an international oil price below $70 a barrel. Goldman sees this factor to be a key driver of oil prices in the medium-term outlook. 

The members of OPEC and their non-OPEC partners are voluntarily holding back production of 1.2 million barrels a day to support higher prices. It’s also true that U.S. sanctions on and the economic crises in OPEC-member nations Iran and Venezuela have removed another 3 million barrels a day from global markets. 

But there’s no guarantee all that oil will suddenly pour back into the market either. Venezuela’s road back to oil relevance will be long even if the Trump administration succeeds in ousting President Nicolas Maduro. 

The Trump administration also doesn’t look like it’s about to ease up on Iran anytime soon. Would a change of administration in the White House make any difference for Iran? Possibly. But sanctions, once imposed, usually stick around for years, and it’s not like U.S. voters are demanding a return to President Obama’s nuclear deal with Tehran. 

Oil prices will likely rise if a Democrat wins the White House, though, due to the anti-drilling and fracking positionsthe party has staked out. 

As for OPEC, it will be eager to claw back the market share it’s lost in recent years to U.S. producers – but the need of OPEC members to bolster their finances should temper the worst of these desires. Even the cartel’s lowest-cost producer and de facto leader, Saudi Arabia, has been running large budget deficits in recent years due to low oil prices. Oil revenues will be more critical than volumes for OPEC members, so the cartel may not abandon its current market management policy even if prices pushes beyond $75 a barrel. 

That type of recovery would serve the entire industry well, particularly the troubled oil services sector which has borne the brunt of low prices. 

Oil services companies have taken significant steps to improve razor-thin margins – laying off workers, reducing excess drilling and fracking capacity, and rethinking business models. Substantially higher oil prices would lift share prices, generate greater investor interest, open up key capital markets, and allow the sector to breathe freely for the first time in years. That’s critical for the long-term health of the global energy system.

It may be difficult to see now, but the fundamentals are in place for substantially higher oil prices in the medium-term. We may not see oil exceed triple-digits again, but $80 would be a sight for sore eyes for much of the industry – and a condition the global economy could absorb without much harm.  

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