Oil Supply and Demand: Famine to Feast?
We've lowered our near-term forecasts, but the pendulum could quickly swing back to oversupply.
As Russia’s invasion of Ukraine drags into its second month, there is just as little clarity in the oil markets as there was a month ago. The flow of Russian volumes to the global market has clearly been disrupted, evidenced by oil prices remaining over $100 a barrel, but exactly how much is uncertain, with estimates in a range of 1-4 million barrels a day. Western buyers continue to self-sanction, avoiding Russian volumes at all costs, while opportunistic buyers in Asia capitalize on the wide discounts. A negative demand impact will result from higher prices and lower GDP growth, but our estimates suggest it won’t fully offset lost supply. That leaves U.S. producers, OPEC, or Iran as the only potential for a near-term supply response, but each is unable or unwilling. As such, we expect a tight market and high prices to persist in the short run. However, by 2024, we see U.S. growth, the full resumption of OPEC production, and the return of Iran volumes tipping global markets into oversupply and undercutting prices. Eighteen months is a long time in the oil markets, though, and a U.S. recession (unlikely, in our view) or failure to reach a deal with Iran or the unknown unknown could quickly change this outlook.
Global Crude Oil Overview
The crisis in Ukraine is evolving quickly, with lots of moving parts. At this stage, significant disruption is inevitable, but the magnitude of the impact on oil markets is still highly uncertain. We will continue to revise our estimates as the situation develops, but for the time being, we have lowered our oil supply forecasts by about 2.3 mmb/d for 2022 and 0.8 mmb/d for 2023. The decrease reflects the impact of sanctions on Russian production and exports, offset partially by the expected response from other producers, which in turn will be partially offset by oil demand destruction related to higher prices and slower economic growth, especially in Russia itself. We have lowered our oil demand forecasts by 0.7 mmb/d for 2022 and 0.6 mmb/d for 2023. The net impact leaves the market looking even tighter than it already was for 2022 and 2023. We anticipate a draw of over 450 million barrels from global crude inventories, dwarfing the 180 million barrels that the Biden administration has pledged from the U.S. Strategic Petroleum Reserve.
The ongoing supply crunch is well understood and is already manifesting in sharply elevated oil prices. What is not yet widely discussed is the looming overcorrection. This reflects rising U.S. production, despite shale companies maintaining capital discipline, coupled with more OPEC volumes (the cartel is failing to hit its own ambitious targets but is delivering persistent growth nonetheless). The oversupply risk is predicated on the thawing of U.S.-Iran relations, a huge wild card. We assume these volumes come back in 2023, with a glut in 2024-25. If a deal is done more quickly, the oversupply could arrive even sooner.
Ukraine Crisis’ Impact on Oil Supply
The U.S. and EU sanctions were initially designed to keep oil and gas flows from Russia intact to limit the blowback on Western economies from rising commodity prices. The United States eventually went a step further and banned all Russian oil and gas imports, though this was largely symbolic, given that the U.S. imports no Russian gas and only 3.5% of its oil consumption is sourced there. The European Union has considered following suit, but there is much disagreement among member states on whether this would do more harm than good. An outright EU ban still seems unlikely, given the lack of alternatives. Theoretically, that leaves Russian oil exports relatively unscathed in the short run. But because buyers are reportedly self-sanctioning, it seems likely that the global appetite for Russian crude has severely contracted anyway. The resulting surplus will be exacerbated by dwindling domestic consumption, and there is limited capacity to store what cannot be exported. With nowhere for the crude to go, Russian producers are being forced to shut in certain volumes.
Not all buyers are averse to Russian crude, though, especially when it’s going for a song. The widening discount of Russian Urals crude to Brent suggests that demand for Russian crude really is drying up (supporting anecdotal evidence of self-sanctioning). There’s no clear data yet on how widespread the self-sanctioning is, or how much other buyers, especially outside the U.S. and EU, will be tempted by this heavily discounted crude. Accordingly, the estimates for the impact on Russia’s oil supply are wide, in a range of 1-4 mmb/d (compared with prewar exports of about 5 mmb/d).
Russia could still curtail its own oil exports, too. We maintain that an absolute embargo is unlikely, as the exemptions allowing crude and natural gas exports are a lifeline enabling Russia to generate foreign currency. But perhaps smaller-scale interventions are already happening. The Black Sea Caspian Pipeline Consortium was allegedly damaged on March 22, reducing its export capacity by 1 mmb/d for as long as two months while one of its three loading facilities is repaired. The pipeline operator claimed at the time that a second facility may also be damaged. This could be a coincidence, but the timing does suggest that the restriction is intentional. The impact on supply will be incremental to anyone self-sanctioning, since the 1.4 mmb/d pipeline primarily exports Kazakh, rather than Russian, oil.
Ukraine Crisis’ Impact on Oil Demand
Partially countering the disrupted oil supply is the demand destruction that is likely to occur as a result of the sharp rise in prices and the reduction in GDP from higher inflation that either reduces consumer spending or prompts greater tightening from central banks. In total, we think the result will be a 1.3 mmb/d (1.3%) reduction in 2022 oil demand compared with our prewar expectations.
Assuming oil prices average $101/barrel in 2022, an increase from $76/barrel at the beginning of the year, we project a 0.7 mmb/d (0.7%) reduction in demand from our prior forecast. Assuming a reduction in 2022 GDP growth to 3.2% from 4.0% previously, we estimate oil demand will be 0.6 mmb/d (0.6%) lower than the prewar forecast. Both estimates are based on our assumptions of one-year price and income elasticity. Although these are the only two oil demand adjustments we are making, other factors could play a role, including COVID-19 lockdowns in China (negative) or more robust travel demand, given the relaxation of COVID-19 measures elsewhere (positive). We assume these are collectively a wash at this point.
We expect the impact of higher prices and inflation to wane over time, leaving our long-term oil demand forecast unchanged. While the economic hit to Russia could persist, given sanctions, and drag on global GDP, the impact should be marginal. Meanwhile, higher prices should wane as new oil supply is added and the global economy adapts to higher prices, mitigating the long-term price impact on oil demand.
OPEC on Sidelines as World Hunts for Alternatives to Russian Oil
Despite pressure from much of Europe and the U.S., OPEC has remained largely united on the production front and has thus far resisted calls to increase its rate of output, sticking with its planned monthly increase of 400 thousand barrels a day. The cartel is likely concerned not only about risking oversupply if disruption to Russian supply does not persist, but also about undermining future cooperation with Russia, which remains part of the broader OPEC+ coalition.
OPEC increased production by approximately 440 thousand barrels of oil equivalent a day in the month of February. The output was a marked improvement from the prior month’s modest gains, but the cartel remains about 700 mboe/d short of its stated targets. Saudi Arabia, the world’s largest oil exporter, contributed nearly 150 mboe/d to the month’s increases; it was recently hit by a Houthi strike, which reportedly damaged two storage tanks. Though the attack was far less consequential than the 2019 Abqaiq strike that knocked 5.7 mmboe/d of supply capacity briefly off line, the continued Houthi activity is an additional overcoat of risk to Saudi supply. OPEC also benefited from an increase of over 100 mboe/d in Libyan production. Reported Libyan volumes often belie gross output, as warlord Khalifa Haftar controls several facilities and supplies oil to the illicit market to generate revenue for political capital.
Outside of a change to the planned monthly increases, there are two options to increase OPEC supply—Iran and Venezuela—but both look increasingly remote in the near term. The Biden administration has reportedly rejected calls from Chevron, the lone U.S. oil company remaining in Venezuela, to relax sanctions and allow it to increase production. While Chevron’s supposed plan to double Venezuela’s estimated 800 mb/d production within months is unlikely, it would probably result in greater production in the next few years than would otherwise be possible. In Vienna, negotiations with Iran on restarting the Joint Comprehensive Plan of Action—the agreement on the country’s nuclear program that would allow the export of more oil—have reached a point of tedium, likely preventing volumes from returning this year. We continue to model a return beginning in 2023.
Are U.S. Shale Producers Getting Carried Away Again?
The crisis in Ukraine has focused the market’s attention on the immediate oil supply deficit, and with good reason: It seems inevitable that Russian supply is being disrupted to some degree, leaving an already-tight market with even fewer barrels. But we think investors should start looking a little further ahead.
In recent years, U.S. producers have typically played the swing producer role, along with OPEC. But a widespread focus on capital discipline has left U.S. producers with less appetite to capitalize on soaring prices than they would have in previous cycles. The reluctance to ramp up and fill the potential void also reflects the reality that while U.S. production is considered short-cycle, it still takes three to six months from allocating capital to seeing a supply response. Management teams are also cognizant of the backwardated futures strip, which means that if the conflict comes to an end more quickly, the favorable price environment may have faded before companies are able to take advantage—even if they start right now. The failure of OPEC to hit its targets, even though output has been persistently growing, coupled with a sluggish U.S. response to strong price signals has convinced the market that a scarce oil supply environment is the new normal.
We think that’s shortsighted. The post-COVID-19 oil demand recovery had largely played out when the Ukraine crisis began, whereas the oil supply recovery was in its early stages. While OPEC won’t reach its lofty targets, we do think it can maintain its current growth path for most of this year, and the U.S. rig count has kept ticking higher. Even after incorporating our reduced forecasts for oil demand (due to higher prices) and supply (due to Russia sanctions), we think the Goldilocks level for U.S. rig activity in oil plays is 400 rigs if Iran exports are restored and 500 rigs if they aren’t. This month, the actual level crept above 550 and is likely to reach 600 during 2022. A swing back to a surplus would be much needed initially to restore depleted inventories, but if left unchecked, an unwelcome glut could manifest by 2024.