Oil fundamentals look healthier than they’ve been for years, largely due to voluntary curtailments from OPEC and its partners. By giving up 1.8 million barrels per day, combined, this group has engineered a temporary supply shortage in an effort to realign global inventories with the long-term average before the cuts expire at the end of 2018.
As many expected, OPEC announced on November 30 that it will extend its crude-oil production cuts through the end of 2018. The impact of these cuts will fall short of what the cartel and its partners are hoping for, however. Several months of stagnating shale growth, driven by a sharp increase in drilled-but-uncompleted wells and the fallout from Hurricane Harvey, have lulled oil markets into a false sense of security.
Even before the OPEC cuts are lifted, supply is likely to outstrip near-term demand growth and tip the industry into oversupply in 2018, driven by rapidly growing U.S. output. Our 2018 and midcycle forecasts for West Texas Intermediate are still $48 per barrel and $55 per barrel, respectively.
Despite our bearish outlook for near- and long-term oil prices, we see pockets of opportunity in the oil and gas space. Energy sector valuations look fairly valued at current levels, with an average price/fair value estimate of 0.98. Still, on a relative basis, energy is one of the cheaper sectors, with several others trading at a price/fair value above 1.05.
The inevitable resumption of growth in the United States, coupled with expansion in Libya and Nigeria, will probably nudge crude stockpiles higher again in 2018, whether other OPEC members comply with fully agreed production targets or not. What’s obvious by now is that current oil prices provide economics that are very attractive to the major U.S. shale producers. This has created the conditions that will allow tight oil to grow rapidly, and is a reality that even forthcoming cost inflation will not change.
Unless shale producers become more disciplined or OPEC resigns itself to permanently ceding market share to U.S. producers, oil markets have major problems looming on the horizon. Neither is likely to occur. The U.S. horizontal rig count remains well below the 2014 peak, but due to remarkable advances in efficiency and well productivity, it is already high enough to drive very strong growth for several years.
The US shale industry still has a long runway of Tier 1 drilling opportunities, especially in key growth basins, the Permian, for example. And there’s ample scope for further advances in productivity and efficiency, offsetting any cost reinflation from shale service providers and capping break-evens for marginal producers. Therefore, next year’s output is likely to exceed the “call on U.S. shale.”
But the industry can’t react quickly when it recognises the danger because many of its rigs operate under fixed-length contracts with steep termination penalties. And when the rig count does decline, there will be an additional overhang related to the lag between drilling a well and bringing it online. Nothing is ever certain in the world of oil, but a crude awakening for energy investors could very well be near at hand. Looking past 2018, we expect a midcycle price of $55 per barrel WTI.
This estimate is based on our cost outlook for US shale production, which we expect to be the marginal source of global supply. Sustainably lower shale break-evens mean the era of low-cost oil is here to stay. Our view on lower shale costs is driven in large part by our expectations for minimal inflation in proppant and pressure pumping costs.
