Miller/Howard Investments

Crude Oil Outlook

March 30, 2016  |  Michael Roomberg, CFA, Portfolio Manager/Research Analyst

Hello, this is Michael Roomberg with Miller Howard Investments. Today I'm going to talk a little bit about the oil markets and some of the major factors that are influencing the trajectory of oil prices moving forward. While I'm not going to provide a specific price forecast, I want to talk about the framework in which we are evaluating the major factors that are influencing supply, demand, and consequently oil prices.

The world's oil wells today will produce about 96 million barrels of crude oil. Demand among all people worldwide will be about 94.5 million barrels. What that means in very real terms is that about 1.5 million barrels of crude oil will have to enter storage somewhere around the world today. As will all commodities the oversupply situation has led to a price response in the market, and the price of crude oil has collapsed over the last 18 months. However, the low current level of pricing is having a large impact on the level of demand and the level of supply. Today I'm going to talk a little bit about specifically what those impacts have been and we expect will continue to be.

[00:02:00] On the demand side of the equation in a normal year over the last 20 years the average increase per year in crude oil demand has been about 700,000 barrels per day. As a result of low prices both US and international consumers are consuming oil at a growth rate of about 1.2 million barrels per day, per year. What that means is that by year end, if nothing else changed, our 1.5 million barrel per day oversupply would decline to about 300,000 barrels per day. The key factors are in places like in China, which accounts for about 40% of that 1.2 million barrel growth expectation. Of course, in the US we're seeing it in the earnings of companies like GM and Ford, which can't keep enough SUVs and trucks on their lot, as US consumers clearly suffer from a case of amnesia with respect to low prices and are returning to buying less fuel efficient vehicles.

In terms of the major risk factor to this 1.2 million barrel a day growth estimate, aside from China, is recession in the US or in Europe. To put this in perspective, during the great recession in 2008‒2009, from peak to trough worldwide, oil demand declined by about 2 million barrels per day. I give you that in context, not because we expect a recession to emerge, but because of the magnitude of the growth outlook from here and what the risks to that outlook may be. Of course, less economic activity will lead to a lower level of crude oil consumption.

On the supply side, the major variable and unknown is the production and export capacity of Iran. As everyone on this call is likely aware, the outcome of the Iran deal has enabled Iran to re-enter the global crude oil export markets. The country is claiming that it will immediately respond by increasing exports by about 500,000 barrels a day and by year end by about 1 million barrels per day. No one including the Iranians is certain of exactly how much capacity the Iranians can bring online. We've already seen their significant administrative hurdles in terms of shipping, insurance, and administrative export duties that have limited Iran's ability to re-enter the market.

[00:04:00] Now Iran had previously indicated an immediate growth rate of 500,000 barrels per day. In its first full month in February the country exported an incremental 220,000 barrels per day, falling well short of expectations. There are also technical and capital resource availability barriers to Iran bringing on more production. So we think all of this taken together suggest that a conservative but realistic assessment of where Iran will be at year end is an increase of about 700,000 barrels per day. We were still 300,000 barrels oversupplied after taking into account the increase in demand. With Iran's 700,000 barrels a day, we find ourselves once again in an oversupply situation of about 1 million barrels a day. Were that to occur we would likely overtop the tanks of many of the storage facilities around the world and consequentially we'd see a more significant downturn in the price of crude oil.

We don't expect that and here's why. The world's oil wells are wasting assets. What that means is that each day that goes by the productivity of an oil well declines as the pressure in the reservoir below is released due to the declining volume held in the formation.

Geologists well know the average decline rate of wells around the world. It runs about 5% per year. What that means is that if we didn't drill any wells in 2016 to offset decline in global oil production would decline by about 5% or about 4.8 million barrels. Of course given the numbers that we've discussed so far, we would enter a period of significant shortage were that to come to pass and oil prices would have to rise dramatically by a factor of two or three.

[00:06:00] Thankfully that's not likely to occur. The reason is because production and new drilling activity hasn't declined to zero but it has declined by about 70%. The net effect of declining existing wells, plus a lower level of new supply, suggest to us that non-OPEC producers will collectively see their production decline by about 1 million barrels per day by the end of the year, a little more than half of which is likely to come from US shale fields. As a result, we have a 300,000 barrel a day oversupply when we factor in demand, Iran's reentry to the market increases oil by about 700,000 barrels, and the balancing factor, which brings the market back into equilibrium, is the economically rational response from global oil producers that are not party to OPEC.

If this were to continue at current prices and current prices were not sufficient enough to incentivize enough drilling activity to increase the level of production among these producers by year end, then the market equilibrium that existed at year end would turn quickly in 2017 to a period of undersupply as growth continued and not enough new wells were brought online to offset the decline from existing wells. We think the market will be in balance by year end and the prices will have to rise to a level that is sufficient enough to incentivize enough drilling capacity in order to meet the likelihood of continued growth and to offset the existing declines.

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