- Crude fundamentals continue to look healthy despite OPEC's June decision to increase production by 600,000 barrels a day beginning in the third quarter of 2018. OPEC's cuts have largely served their purpose, with oil inventories having shrunk considerably in the past several quarters. We had always projected that OPEC and its partners would eventually turn the spigots back on, given OPEC's lack of history sustaining longer-term production cuts.
- Helping OPEC's efforts are geopolitical supply disruptions coupled with temporary Permian pipeline shortages. Venezuela remains in crisis, and its oil production has slumped further after an initial plunge in the fourth quarter of 2017. U.S. President Donald Trump's decision to abandon the Iran nuclear accord is likely to widen this year's crude oil supply-demand imbalance, accelerating the decline of global inventories and potentially leaving the market with fewer days of supply on hand by year-end than it has had at any point in the past eight years.
- However, we believe the market continues to underestimate the capacity of the shale industry to eventually throw oil markets back into oversupply. U.S. production reached a new high-water mark in June and should keep hitting new records, though that may come in fits and starts due to temporary Permian pipeline shortages.
- Crude prices have largely held above $65 per barrel for West Texas Intermediate in 2018, which provides attractive economics for many U.S. producers. Eventually, we expect pain for oil prices as growing U.S. production serves as the primary weight to tip oil markets back into oversupply. Our midcycle forecast for WTI is still $55/bbl. We think oil bulls are failing to recognize the potential for further productivity gains from U.S. producers and are unduly worried about prime shale acreage running out more quickly than it really will.
- Despite our bearish outlook for long-term oil prices, we see pockets of opportunity in the oil and gas space. The energy sector currently trades at an average price to fair value estimate of 0.99, with more opportunity in industries like midstream that are less dependent on the oil price level and more overvaluation in industries like oilfield services that have a much higher oil price beta.
We previously viewed the late 2017 decline in global crude stockpiles as a temporary respite, to be derailed by the shale surge that grew ever more inevitable due to the positive impact high oil prices have on oil production. However, economic malaise in Venezuela has triggered precipitous output declines, and it isn't clear how quickly this can be rectified, if at all. The likelihood of hefty outages in Iran has soared now that Trump abandoned the Iran nuclear accord. All this creates a supply vacuum this year that can easily offset U.S. growth, however strong, and prolong the illusion that shale isn’t a threat. Regardless, oil prices must pare back eventually to prevent catastrophic growth from U.S. shale.