The Dynamics Behind Oil

Telemus Weekly Market Review March 7th - March 11th, 2022

Commodities took center stage this past week with, with oil sitting in the center of the spotlight. The price of crude oil shot higher the week prior on speculative trading given the Russia/Ukraine conflict. Oil prices remained volatile this past week, getting a jolt from President Biden’s decision to cease U.S. purchases of Russian oil. Oil traders seemed to be buying the rumor and selling the news, as West Texas Intermediate (WTI) crude prices fell in the back half of the week, ending down -5.5% to close at $109.33 a barrel.

To help unpack the fundamentals behind oil prices, it’s helpful to start at the economic building blocks, supply and demand. Global crude oil consumption, or demand, is forecast to be 100.6 million barrels of crude oil per day¹ in 2022. Worldwide production, or supply, is expected to reach 101 barrels a day in 2022¹. Global supply is beginning to ramp with an expected 5.5 million barrels a day increase in 2022 versus 2021. Forecasts for 2022 are based on expectations for accelerated production coming out of OPEC+ and the United States.

The U.S. is now the largest producer of oil worldwide with Saudi Arabia and Russia not far behind. U.S. production of roughly 12 million barrels a day is still not large enough to satisfy its daily demand of 20 million barrels. As such, the U.S. needs to import oil, including an average of 672,000 barrels a day from Russia. Given President Biden’s announcement this week that the U.S. would no longer import Russian oil, this supply will need to be replaced. Its magnitude is not that material, accounting for a little over 3% of U.S. daily demand. Higher crude prices are likely to incent additional drilling activity as returns on investment have become more attractive.

Oil drilling is anything but consistent. For some properties, oil reservoirs are shallow, making drilling easy and economical. Alternatively, other properties may require deeper drilling and fracturing of the rock (i.e., fracking) with sand and water. This approach, while effective, entails a higher cost of production and can vary considerably depending on the formation of the rock and ease of the drilling process. Fracking technology is fairly new and has fueled a renaissance of drilling in the United States over the past two decades, propelling the U.S. as the largest supplier.

Given these variations in geological structure, shallower fields, such as the Permian Basin in Texas, have lower breakeven production costs. Other areas, such as the Bakken shale fields in North Dakota, which utilize fracking, require higher breakeven oil prices. Given these differences, high cost of production fields are likely to increase activity as oil prices rise. With oil prices now above $100/barrel, the economics would justify an acceleration in drilling activity. A report by the U.S. Energy Information Administration highlight that U.S. production could grow to as high as 20 million barrels a day at high oil prices. The chart below from this report highlights the potential range of production based on oil prices.

Source: U.S. Energy Information Administration, 2022 Annual Outlook

While incremental production can help stem the impact from any reductions in global consumption of Russian oil, they are unlikely to be enough sources to offset the full 11 million barrels a day of Russian output. The impact is likely to be hardest felt in Europe, where central and eastern European nations are most reliant on Russian oil and gas. Alternatively, the impact on the U.S. will be more manageable given alternate sources of production. This dynamic is likely to lead to a wider variation in quoted oil prices between West Texas Intermediate (WTI) crude and Brent Crude. WTI crude prices reflect market prices in the U.S., while Brent Crude reflects market prices in Europe. The spread between Brent and WTI has averaged around $2 a barrel in recent years and could widen given global supply/demand imbalances.

Natural gas, on the other hand, is unique relative to oil. Gas is more of a regionalized commodity and hence prices can vary considerably by geography. The reason for this is transportation as gas can only be shipped via pipeline or liquified into LNG (liquified natural gas), where it can then be transported to a regasification facility. The use of LNG is newer technology and any notable uptick in LNG demand would be constrained by the limited infrastructure for both liquification and regasification.

Ultimately, the Russia/Ukraine conflict is likely to lead to higher near-term oil and gas prices throughout the world. We expect incremental production to come online and blunt some of the impact, however, it’s a stretch to believe existing resources can replace the 11 million barrels a day of oil that Russia produces. Over time, we could see shifts in the global supply chain where Russia reallocates its oil away from western countries, and other producers begin to supply European nations. On the gas front, if anything, the conflict may ignite spending around LNG infrastructure. However, this will take time to build out. Therefore, prices, particularly in Europe, are likely to remain elevated for some time.

We’ve seen numerous episodes in the past where energy prices rise considerably and inevitably fall. It’s the nature of the commodity cycle. We are clearly on an upcycle, at present, that has the underpinnings to sustain itself. As such, having exposure to commodities, including oil and gas, is not imprudent in this heightened inflationary environment. However, supply and demand will inevitably balance out and we would expect prices to trend back toward equilibrium over the long-term.