Short-term volatility has clouded the market's view of longer-term fundamentals in energy.
--Recession fears this summer shaved more than $20 per barrel off of oil prices and led to similar percentage declines in many energy stocks, leaving the sector as a whole attractively priced.
--Despite economic noise from Euroland and the U.S., our focus is on China, and specifically whether it can successfully navigate a shift from an investment-driven to a consumption-driven economy, and the implications for oil demand.
Troubles in Euroland and renewed recession fears in the U.S. led to a sharp sell-off of stocks and commodities, hitting the oil patch particularly hard. However, we think short-term volatility has clouded the market's view of the longer-term fundamentals that we believe will continue to be the underlying drivers in the energy sector. In our view, a double-dip recession here and in Europe certainly would reduce developed-market demand for oil, in a reprise of 2008-2009. This would help a market that has been under-supplied since the middle of 2010 come back into balance, suggesting that we could settle into a new, lower equilibrium for oil prices.
Four factors keep us from moderating our view that higher oil prices are likely over the medium term. First, global crude oil supplies have been struggling throughout 2011. While OPEC production is now back to pre-Libya levels, thanks largely to efforts by Saudi Arabia, it is unclear whether this incremental production represents a short-term surge or something more sustainable. Meanwhile non-OPEC production is falling, despite accelerating production offshore Brazil and the resurgence of U.S. production, thanks to shale oil.
Second, we estimate that major OPEC producers and Russia require oil prices around $90-95 per barrel to balance national budgets, suggesting that exporters will again make efforts to defend oil prices in the face of a sustained downturn.
Third, emerging-markets demand growth continues to consume greater than 100% of incremental supply growth. In other words, China and other emerging countries are using every bit of the world's new oil production while requiring developed countries to make due with less.
Fourth, while a "hard landing" in China would be enough to tank oil prices in the short run, it would also result in prices low enough to discourage investment in new production. This would lead to higher oil prices as natural production declines tighten supply in the absence of new investment.
Gas-focused E&Ps, and increasingly, "oil" majors, continue to see low selling prices and little reduction thus far in gas production. For the near term, gas supply and demand fundamentals continue to weigh on prices, but we expect tighter environmental regulations for coal-fired generation to provide a needed catalyst for increased gas demand, suggesting improving fundamentals beyond 2011. On the supply side, gas-directed rig counts have fallen roughly 10% year over year, less than we had hoped to see by this time. Instead of a full gas drilling pullback, we've seen E&Ps shifting rigs from noncore dry gas acreage toward liquids-rich gas plays, where the associated natural gas liquids stream can materially boost netbacks.