The continued deterioration in global oil demand has compelled us to again lower our oil price outlook for 2009 to an average of $45/bbl from $75/bbl previously, though we see a growing number of signs that oil markets have entered the bottoming phase of the cycle.
Despite our lowered oil price deck, this is not a call that we are incrementally more bearish on Energy equities. Our global energy team is, however, continuing to stick to a defensive posture within the Energy sector in terms of our top picks, though we have gained comfort in recommending select higher-beta stocks that we might call “offensive defensive” ideas (primarily hedged E&Ps with transformational growth opportunities).
We think a move back to high-beta names that would benefit from a future rally in oil prices is still several months away, pending greater confidence that demand is no longer deteriorating and supply is on-track to decline sharply. The latter we think requires a longer period of oil around $40/bbl (or lower) than we have currently seen; demand globally also shows no signs of improving.
We think that the sharp and sudden collapse in global oil demand exceeds OPEC’s ability to, on its own, balance markets, and necessitates sharply lower non-OPEC crude oil supply.
Unlike OPEC, we believe non-OPEC producers will reduce production and sharply cut capital spending only if cash flow is sufficiently weak, which we believe is the case at oil prices in the $40-$50/bbl range.
However, because there is a lag between capital spending cuts and evidence of lower production—and demand is incredibly weak right now—oil prices may need to fall further to levels that stimulate non-OPEC producers to accelerate activity declines and possibly even shut in production, which we think will occur at oil prices around $30/bbl.
While global oil demand is very weak and the duration of demand weakness is unclear at this time, we believe oil supply will collapse if prices remain below $40/bbl for an extended period of time (6-12 months or longer) suggesting we are likely to have entered the bottoming phase of the cycle.
• Oil prices are now meaningfully below the $60/bbl level at which the average company earns a cost-of-capital return on longterm investments based on current costs; capital spending reductions have begun.
Oil prices have traded near the $40/bbl level below which we think short-cycle activity will be sharply curtailed, which should accelerate near-term declines in supply.
• Industry returns on capital are near historic trough levels at a $45/bbl WTI oil price.
• The WTI forward curve is in “super contango” that historically has coincided with the weakest portion of the cycle.
What is not clear yet is how long the bottoming phase will last. Global economic conditions are the weakest the world has seen since at least the early 1980s and global oil demand is declining at an accelerating rate. In our view, the duration and depth of the downturn will be decided by the interplay of global oil demand weakness and non-OPEC supply declines.
Global oil demand has weakened to the point that OPEC cuts alone are unlikely to return the market to balance, with greater declines in non- OPEC supply now required.
In terms of gaining confidence that a bottom is at hand and a recovery possible, we would need to see the following:
• Demand: A deceleration in the rate of global oil demand declines is critical (no signs yet).
• Non-OPEC supply: A sharp reduction in short- and long-term capital projects is required (early signs emerging).
• OPEC supply: It will be important for OPEC to announce additional cuts at its December 17, 2008 meeting in Oran, Algeria in order to gain confidence that OPEC’s “Big 3” of Saudi Arabia, Kuwait, and UAE are on-track to reduce production by the 2 mn bbls per day.
Despite our lowered oil price deck, this is not a call that we are incrementally more bearish on Energy equities. Our global energy team is, however, continuing to stick to a defensive posture within the Energy sector in terms of our top picks, though we have gained comfort in recommending select higher-beta stocks that we might call “offensive defensive” ideas (primarily hedged E&Ps with transformational growth opportunities).
We think a move back to high-beta names that would benefit from a future rally in oil prices is still several months away, pending greater confidence that demand is no longer deteriorating and supply is on-track to decline sharply. The latter we think requires a longer period of oil around $40/bbl (or lower) than we have currently seen; demand globally also shows no signs of improving.
We think that the sharp and sudden collapse in global oil demand exceeds OPEC’s ability to, on its own, balance markets, and necessitates sharply lower non-OPEC crude oil supply.
Unlike OPEC, we believe non-OPEC producers will reduce production and sharply cut capital spending only if cash flow is sufficiently weak, which we believe is the case at oil prices in the $40-$50/bbl range.
However, because there is a lag between capital spending cuts and evidence of lower production—and demand is incredibly weak right now—oil prices may need to fall further to levels that stimulate non-OPEC producers to accelerate activity declines and possibly even shut in production, which we think will occur at oil prices around $30/bbl.
While global oil demand is very weak and the duration of demand weakness is unclear at this time, we believe oil supply will collapse if prices remain below $40/bbl for an extended period of time (6-12 months or longer) suggesting we are likely to have entered the bottoming phase of the cycle.
• Oil prices are now meaningfully below the $60/bbl level at which the average company earns a cost-of-capital return on longterm investments based on current costs; capital spending reductions have begun.
Oil prices have traded near the $40/bbl level below which we think short-cycle activity will be sharply curtailed, which should accelerate near-term declines in supply.
• Industry returns on capital are near historic trough levels at a $45/bbl WTI oil price.
• The WTI forward curve is in “super contango” that historically has coincided with the weakest portion of the cycle.
What is not clear yet is how long the bottoming phase will last. Global economic conditions are the weakest the world has seen since at least the early 1980s and global oil demand is declining at an accelerating rate. In our view, the duration and depth of the downturn will be decided by the interplay of global oil demand weakness and non-OPEC supply declines.
Global oil demand has weakened to the point that OPEC cuts alone are unlikely to return the market to balance, with greater declines in non- OPEC supply now required.
In terms of gaining confidence that a bottom is at hand and a recovery possible, we would need to see the following:
• Demand: A deceleration in the rate of global oil demand declines is critical (no signs yet).
• Non-OPEC supply: A sharp reduction in short- and long-term capital projects is required (early signs emerging).
• OPEC supply: It will be important for OPEC to announce additional cuts at its December 17, 2008 meeting in Oran, Algeria in order to gain confidence that OPEC’s “Big 3” of Saudi Arabia, Kuwait, and UAE are on-track to reduce production by the 2 mn bbls per day.
