Oil investors don’t like what they see: too much supply and not enough demand.
They don’t like the growing number of barrels being produced in America, Libya, and Nigeria. Nor are they comforted by the sluggish growth in demand caused by the lackluster pace of global economic activity, increased energy efficiency, and alternative fuels.
This one-two-three punch has sent the price of Brent crude oil into its latest bear market, down 21% to $44.92 as of yesterday’s close (Fig. 1).
Energy is the worst-performing S&P 500 sector ytd, down 13.5%, and many of the sector’s industries are doing even more poorly: Oil & Gas Drilling has lost 36.4% ytd, Oil & Gas Exploration & Production has lost 20.5%, and Oil & Gas Equipment & Services is down 19.3% (Fig. 2 and Fig. 3).
Most other S&P 500 sectors have been enjoying much better ytd performances through Tuesday’s close: Tech (18.2%), Health Care (14.4), Utilities (11.0), Consumer Discretionary (10.3), Materials (9.0), Industrials (8.9), S&P 500 (8.9), Consumer Staples (8.8), Real Estate (5.5), Financials (4.6), Telecom Services (-10.5), and Energy (-13.5) (Table).
Let’s take a look at the push and pulls affecting the price of black gold:
(1) The US is pumping. In Q1, the amount of oil being produced and the amount of oil being consumed weren’t that far out of whack. Total world demand was 96.5 mbd in Q1, and total supply was 96.6 mbd, according to the International Energy Agency’s (IEA) 5/16 Oil Market Report. That’s a significant improvement from Q4-2016, when demand was 97.7 mbd and supply was 98.3 mbd. OPEC’s production cut of about 1.8 mbd, which began last year and is expected to continue through March 2018, looked like it was balancing the market until recently.
However, continued supply growth out of the US and production rebounds in Libya and Nigeria subsequently have overshadowed OPEC cuts. US crude production hit 9.35 mbd after rising by 20,000 barrels during the week of June 16. As a result, production is not far from the peak amount produced during the week of June 5, 2015, 9.6 mbd (Fig. 4). Production never fell as dramatically as the US oil rig count, as producers managed to coax more oil out of existing wells. And after bottoming in late May 2016 at 316, the number of US rigs has increased to 747 (Fig. 5).
Those rigs have been awfully busy. At the end of May, there were 5,946 drilled-but-uncompleted wells, the most in at least three years, according to estimates by the US Energy Information Administration (EIA). “In the last month alone, explorers drilled 125 more wells in the Permian Basin than they would open, meaning production could surge when they turn on the spigots,” a 6/19 Bloomberg article reported.
The US isn’t the only country increasing production. Libya is producing 902,000 bpd, up about 200,000 barrels since April because two fields returned to production. It’s the most the country has produced since 2013, when production hit 1.13 million bpd, another 6/19 Bloomberg article reported. Libya is exempted from the OPEC production cuts.
(2) Brimming inventories. Excess production has kept US inventories stubbornly high. For the week ending June 16, US crude oil inventories (excluding those in the Strategic Petroleum Reserve) decreased by 2.5 million barrels to 509.1 million barrels, according to yesterday’s EIA report. That still leaves inventories slightly above where they stood last year, at 500.0 million barrels, and far above where they stood in the three years prior to that (Fig. 6).
High inventories in other countries around the world are prompting oil traders to store increasing amounts of oil at sea. “The amount of oil stored in tankers reached a 2017 high of 111.9 million barrels earlier this month, according to Paris-based tracking company Kpler SAS. Higher volumes of storage in the North Sea, Singapore and Iran account for most of the increase,” yet another 6/19 Bloomberg article reported. “As recently as May 1, the average volume was about 74 million barrels, according to Kpler.”
(3) Sluggish demand. Global demand growth for oil in Q1 was only 0.9 mbd, according to an IEA report. However, the agency expects demand to pick up in the second half of the year, bringing full-year demand growth to 1.3 mbd in 2017 and 1.4 mbd in 2018, as worldwide demand reaches a record of 99.3 mbd.
Those projections may be tough to hit if the recent drop in demand for gasoline doesn’t go into reverse. Gasoline usage has dropped to 9.23 mbd during the week of June 16 from a peak of 9.37 mbd last fall. The drop in gasoline usage is of note because the number of vehicle miles traveled has continued to climb to record highs (Fig. 7). It could have much to do with the improved fuel efficiency of US cars. By our calculation, the average miles per gallon is 22.4, near the record hit in October 2013 when gas prices were much higher and there was more demand for smaller cars (Fig. 8).
The number of electric vehicles on the road also bears watching, as it may be affecting demand on the margin. For the year ending November 2016, more than 130,000 hybrid or battery-powered vehicles were sold in the US, almost double the 73,000 vehicles sold in 2012, notes a 12/21 Recode article. That’s still far from the average 17 million total cars sold in each of the past three years in the US. But the number may be about to jump once again, as Tesla’s $35,000 Model 3 is expected to hit the market this year.
(4) Prince of Arabia & Vision 2030. According to Time: “Undoing decades of royal tradition, Saudi Arabia’s King Salman appointed his 31-year-old son Mohammed Bin Salman to be next in line for the throne on Wednesday, signaling a historic political shift in one of the Middle East’s key regional powers.
“A rising star within the Saudi royal family, Mohammed Bin Salman was already one of the kingdom’s most powerful leaders. He advocates a forceful Saudi foreign policy and is also leading a massive overhaul of the Saudi economy. As the country’s defense minister, he is in charge of Saudi Arabia’s two-year-old air war in Yemen, where more than 10,000 people have died in one of the world’s most dire humanitarian crises.”
In 2016, the prince-in-waiting implemented Vision 2030, a plan to restructure the economy away from its dependence on oil exports. It states: “Diversifying our economy is vital for its sustainability.” On Monday, we advised OPEC countries with large oil reserves as follows: “Rather than propping up the price, maybe OPEC should sell as much of their oil as they can at lower prices to slow down the pace of technological innovation that may eventually put them out of business.” That’s so obvious that a smart young man like Mohammed Bin Salman probably gets it.
(5) Less influence. The S&P 500’s ability to remain near record levels given the selloff in the Energy sector is reasonable—so far. The S&P 500 Energy sector’s market weighting in the S&P 500 has shrunk to 6.0% from its peak of 16.1% in July 2008. Likewise, the amount of earnings it contributes to the broader index is now 4.3%, down from 21.3% then (Fig. 9). So while crude has entered a bear market, its influence on the broader index has fallen as the S&P 500 has continued to hit new highs, Bloomberg rightly noted on 6/20.
The question will be whether the oil bear market will lead many energy companies to shut down production if drilling becomes uneconomic at these lower prices.
A 6/19 WSJ article said many shale producers had lowered their production costs so that they could be profitable when oil fetched $50 to $60 a barrel, and a handful could even turn a profit if the price fell to $40. That certainly isn’t good news for the upcoming Saudi Aramco IPO. Saudi Arabia’s ruling family undoubtedly is watching.
There is usually an obvious reason for selling the family jewels.
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
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