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Q2 2021 Research Theme: Macro Backdrop

Global oil market fundamentals have markedly improved this year, with Brent and WTI attaining 3-year highs of US$78/bbl and US$75/bbl respectively in early July. However, resurgence of the Delta Covid variant and OPEC+’s late July deal to phase-in additional supply have weighed on recent market sentiment and headline oil pricing in turn.

Nevertheless, all major oil benchmarks continue to exhibit steep backwardation (a prime signal of a tight physical market), as oil market fundamentals remain robust alongside further declines in OECD oil stocks. OPEC+’s agreement – although adding future supply to the market – is a net positive for market structure in that it resolves festering tensions between the Saudis and the UAE which threatened cartel integrity and control over market supply.

In common with such bullish market signals, we believe that there is potential for a market deficit by year-end 2021 and, absent a Covid-led ‘curve ball’, global oil markets could remain tight well into 2022.

Improving economic conditions, robust equity markets and vast ongoing stimulus packages underpin a gradual restoration of OECD oil demand while the forecast supply response remains tempered by phased increases in OPEC+ output and anaemic non-OPEC supply growth.

For non-OPEC players, improved capital discipline – whether by choice, lack of access to capital markets or shareholder demands – no doubt contributes to such modest non-OPEC supply growth forecasts.

However, the foundation for non-OPEC’s diminished supply growth despite greatly improved oil pricing lies not in recent Covid-led spending cutbacks but rather in the industry’s substantial, long-term underinvestment in upstream exploration and appraisal – the inevitable result being that the aggregate scale of fresh discoveries, and reserve replacement in turn, has collapsed over the last decade.

Global Exploration Success Has Collapsed Over The Last Decade

Source: Rystad Energy

By way of example, of seven oil majors, none achieved a 100% cumulative reserve replacement ratio over the last five years i.e. entirely replaced cumulative oil production with freshly acquired or discovered barrels. (ExxonMobil: 89%, ConocoPhillips: 78%, Total: 56%, ENI: 56%, BP: 48%, Shell: 29% and Chevron: 16%)

Given the ever-growing environmental pressures on the oil industry – wielded by stakeholders, banks and insurers – such structural deficits in reserve replacement will not readily right themselves.

From 2014, the extraordinary U.S. shale oil boom largely drove non-OPEC production growth, more than compensating for rapidly diminishing global exploration success. However, the same cannot be expected of public U.S. shale players going forward – there will be no Shale Oil Boom 2.0.

Certainly the revival in oil prices has prompted a resurgence of U.S. shale oil activity: the overall U.S. oil rig count currently stands at 405 active rigs, up from 183 year-on-year; the Permian rig count stands at 247 active rigs, up from 127 rigs year-on-year. However, the days of growth at any cost are over: rampant growth in activity is tempered by shareholder demands for returns as well as industry consolidation.

The U.S. shale oil industry is forecast to generate over US$30 billion of free cash flow this year, a record that stands in stark contrast to the estimated US$300 billion cash burn over the prior decade.

With greater capital discipline, U.S. shale oil will no longer provide a ‘reactive’ price-driven buffer within global oil markets – swift additions to production matched by high decline rates. As a consequence, oil markets may well become more volatile over coming years, susceptible to frequent and pronounced price spikes.

Global oil inventories lie just 40 mmbbls above 10-year seasonal average levels, an order of magnitude below the June 2020 peak of 390 mmbbls. With tight market fundamentals and further market rebalancing underway, global inventories will likely diminish further relative to seasonal averages, underpinning oil pricing through year-end 2021 into 2022.

Source: International Energy Agency

The picture for global gas markets is similar. Tightness in the U.S. natural gas market is now manifest in low inventory levels. Having begun 2021 at a 200 bcf surplus relative to the five-year seasonal average, U.S. gas inventories have slumped to a near 200 bcf deficit. The 2021 injection season could result in a 3.2 tcf gas inventory, down 700 bcf year-on-year, representing a 400 bcf seasonal deficit. If such forecasts bear out, U.S. gas inventories run the risk of starting the winter season at the second lowest level in fifteen years. Any sustained bouts of cold weather over winter 2021 would therefore lead to material price spikes.

U.S. gas prices have more than doubled since the September 2020 nadir of US$1.74/mcf and currently stand at $3.95/mcf, up 43% year-to-date. However, despite this rally, there has been little in the way of a drilling response as yet. Only 30 gas rigs have been put back to work since the gas rig fleet bottomed at 68 in July 2020. Just 97 rigs are drilling for gas compared with over 200 as recently as 2019.

Global gas markets also remain tight, with European and Asian LNG prices recently spiking. Dutch gas benchmark prices surged 80% in the past three months to all-time highs, while spot LNG pricing in Asia stands at an eight-year seasonal high. With Asia LNG traders betting that average winter prices will surpass last year's peaks, the average price for a December LNG derivatives contract in Northeast Asia is about $17.65 per mmBtu, up 53% year-on-year.

These global oil and gas energy trends potentially provide a foundation for a further cyclical upswing in the energy sector. Of course, the energy transition to renewables and EVs inevitably impacts the global oil and gas industry. However, not only will the transition likely take a lot longer than either mandated or forecast, but oil and gas will necessarily continue to play a material part in primary energy supply for decades to come, even under the most stringent net-zero forecasts such as that of the IEA.

Meanwhile, operators, NOCs, Majors and IOCs, all remain steadfast in their stated goals to reduce the carbon intensity of their operations to deflect criticism from all manner of stakeholders – consumers, environmental groups and governments alike. We continue to believe that incredible investment opportunities lie in the technologies that will help them achieve those goals.

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