By: Neal Shah, Senior Equity Research Analyst, and Abhishek Sinha, Senior Equity Research Analyst, Thrivent Asset Management April 03, 2017
The oil industry was reeling in early 2016, with prices dipping to well under $30 a barrel. The oil slump drove stock prices down and staggered the economy, as hundreds of rigs were idled and thousands of well-paid workers were laid off from their jobs.
The silver lining came at the pump where consumers were paying well under $2 a gallon.
The oil industry has eked out a slow recovery since then. Oil prices recently rebounded to a range of $50 to $55 per barrel (West Texas Crude). Idled rigs have resumed operation, oil company margins have improved, and laid-off workers have started returning to their jobs, bolstering the economy and the stock market.
And consumers in most states are still paying less than $2.50 per gallon for gasoline. Is this the best case scenario for the oil industry – corporate profits, job growth and reasonable prices at the pump– and how long will this last?
The oil slump was initially created by over-production that created an oil surplus. Currently, supply and demand are closer to balanced, and inventories should drop further as a result of an agreement by OPEC last November to curtail production by 1.2 million barrels per day.
Although there is still an excess in supply versus demand, that gap has been slowly closing recently. In November 2016, OPEC member nations voted to curtail production by 1.2 million barrels per day.
Although OPEC hasn’t reached that goal, member nations have made some cuts, which have helped slice the surplus.
But the rising price of oil has had one other effect that has partially offset the impact of those cuts. It has made it possible for U.S. producers to ramp up production.
So while OPEC is working to reduce production, the U.S. is increasing production, diluting somewhat the effect of those cuts.
The combination of the increased U.S. production and a seasonal bulge in U.S. stockpiles helped drive down oil prices into the high $40s in March, although we believe that may be a temporary dip – barring some unforeseen developments. While the U.S. production hike will compensate for some of the scheduled cuts by OPEC, it won’t replace them entirely. Combine that with the fact that global oil consumption is expected to continue to rise by about 1.2 million barrels per day each year over the next several years, and it seems likely that the supply glut will continue to abate in the near future.
However, that assessment assumes that OPEC will stick to its agreement. The trajectory in oil supplies will become normalized only if we see a consistent drawdown in OPEC production. If OPEC does not extend the cuts through the summer and fall, we may see further downside pressure on oil prices amid the rapid surge in U.S. production.
There are two primary components driving the growth in global oil demand – the strengthening of the global economy and the increasing consumption of oil in India and China. Oil usage is directly tied to the economy. In a slow economy, oil use slows and in a strong economy it accelerates. If the global economy continues to strengthen, oil consumption should continue to rise.
The increase in auto ownership in China may be the single largest driving force behind the rise in consumption. Chinese consumers are purchasing about 22 million new vehicles a year, compared with about 17.5 million in the U.S. The difference, however, is that most of the new purchases in the U.S. are replacing older vehicles, while in China most of the purchases are by first-time owners. The result is a much greater net increase of autos on the roads in China versus the U.S.
The U.S. is also seeing a rise in consumption as the economy and the rate of employment improves, but it accounts for far less of the global increase than China and India.
We expect global oil consumption to continue to rise for the next 10 to 15 years – if the economy stays healthy – before leveling off due to better energy efficiencies.
If oil prices remain in the range of $50 to $65 per barrel, the U.S. oil industry should continue to move toward full capacity. According to Baker Hughes, the count of working rigs in the U.S. has increased by 313 rigs year-over-year through March 18 to a total of 789 rigs.1
While President Trump announced his intention to remove some restrictions on off-shore drilling, we don’t expect that to be a factor in the near term. Off-shore drilling is not economically feasible when prices are under $60 a barrel. And once off-shore activities begin, there is a lag of about three to four years between discovery of a new well and production of oil from that well.
On the other hand, there are certain global political factors that could cause a spike in oil prices. A supply disruption or the imposition of new sanctions on Iran could both push oil prices up beyond $70 per barrel.
Barring a production disruption, however, if oil producing nations are able to keep production at a reasonable level to avoid oversupply, we expect oil to trade in a relatively narrow range. While predicting the price of oil has always been dicey, we expect oil to trade in a general range of about $45 to $65 per barrel – and possibly slightly higher – over the next 12 to 24 months.
Under that scenario, consumers should continue to enjoy gasoline prices in the $2 to $3 per gallon range, and the oil industry should experience reasonable margins and solid earnings.
All information and representations herein are as of April 3, 2017, unless otherwise noted.
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Thrivent Asset Management associates. Actual investment decisions made by Thrivent Asset Management will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.
1. Baker Hughes, Rig Count Overview & Summary Count, March 20, 2017
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