With oil prices surging amid a broader global energy crisis, many are hoping that this particular price spike is truly transitory as incremental supply - whether from OPEC+ or shale - kicks in and resets the market lower.
But maybe not so fast: as Morgan Stanley's chief commodity strategist Martijn Rats writes, on current trends, global oil supply is likely to peak even earlier than demand. And as prices search for the level at which demand erosion kicks in, he is increasing his Q1 2022 Brent forecast to $95/bbl, while also lifting his long-term forecast from $60 to $70/bbl.
As hinted by the bold text above, the note from the Morgan Stanley commodity strategist (available to pro zero hedge subs in the usual place) focuses on arguably the two key drivers in the oil market: peak demand and peak supply. As Rats explains, while tThe planet puts boundaries on the amount of carbon that can safely be emitted - and therefore, oil consumption needs to peak - this is such a well-telegraphed prospect that it has solicited its own counter-response already: low investment (especially in conjunction with ESG pressures to curb fossil fuels). The question has therefore become: which will actually peak first? Supply? Or demand?
According to MS, the second scenario would materialize if demand were to decline very sharply, say along the trajectory of the IEA’s ‘Net Zero by 2050’ study.
This assumes that oil demand falls by ~29% between 2019 and 2030, driven by technological improvements, a change in end-user behaviour and other factors (recent event have shown just how much of a pipe dream this is). The sum of all oil future oil demand in this scenario amounts to ~700-900 bn barrels, roughly half the estimate of proved oil reserves in the BP Statistical Review of World Energy of 1.7 trillion barrels.
As the window of opportunity to monetize these resources closes, this could incentivize the major producing countries to increase output quickly,unleashing competition for market share. As shown in the next chart, most OPEC countries have a much greater share of the world’s oil reserves than of the world’s oil production. Therefore, their the need to take market share could be especially strong.
Under those conditions, the price of oil would probably fall to the marginal cost of production. Taking into account that some of today's high-cost output would no longer be necessary, this price would likely be low – the IEA pegs oil at ~$35/bbl between now and 2030 under this scenario, falling further to $24/bbl by 2050.
That said, this scenario is hardly new and has been firmly on the horizon now for some years – rarely has a major economic inflection point been telegraphed ahead of time as much as ‘peak oil demand’. Therefore, the industry is already responding to this scenario. This reaction – counter-intuitive though it may seem – is rapidly increasing the probability of the alternative scenario: supply peaking well before the peak in demand!
For those who haven't guessed it yet, in its note Morgan Stanley argues that this scenario of peak supply hitting sooner than peak demand, is rapidly becoming the more likely one, and will likely lead to a period of sustained high oil prices.
While the full Morgan Stanley notes dives into much more detail focusing on three key questions:
- How much energy does the world actually need?
- How much of this will be supplied by oil?
- And is the industry on-track to meet this demand?
... we won't dwell much on these - those who are curious about long-term supply/demand dynamics in the oil space are strongly encouraged to read the note - but we will take a look at energy demand which has three powerful drivers: The world's population is expanding by 1 bn every 13-14 years, during which GDP per capita in real terms is set to increase by ~35% as well.
The deeply uneven distribution of energy consumption around the world puts upward pressure on energy demand too. Despite efficiency efforts,energy consumption will still likely grow from ~600 EJ today to ~740 EJ by 2040, MS estimates. The chart below shows that a more-or-less modern lifestyle requires ~100 GJ per head in primary energy supply. At the moment, the world's energy consumption is ~600 exajoule in total. However, if all countries that currently consume less than 100 GJ/head were lifted to that level (and the rest were to remain unchanged) this would bring the world's energy consumption to ~900 GJ.
In any case, there is a huge range of uncertainty about oil demand, and that is reflected in the wide range of estimates
- The OPEC secretariat estimated 2030 demand at 106.6 mb/d in its recent World Oil Outlook, released in September.
- Earlier in October, the EIA – part of the US Department of Energy – released a set of scenarios with 2030 oil demand estimates ranging from 103.4 mb/d to 115.4 mb/d, with a base-case estimate of 109.2 mb/d.
- Last month, S&P Global Platts showed an estimated for 2030 demand of 113 mb/d in its reference case,and still 102.3 mb/d in its most recent 'Two Degree' scenario released in August.
- The IEA showed forecasts in its recent World Energy Outlook (WEO) ranging from 103 mb/d under its 'Stated Policies' scenario, down to 72 mb/d under the 'Net Zero Emissions' scenario. However, these are somewhat in contrast with other figures from the IEA, specifically its medium-term oil market forecasts. In 'Oil in 2021', released in March 2021, the IEA estimated demand to reach 104 mb/d already by 2026.
Clearly, there is potential for large divergence between what will happen and what should happen.
For the purposes of oil market forecasting, Morgan Stanley's working assumption is that oil demand will continue to grow in coming years and still reach a level of ~105 mb/d around the turn of the decade, (based on the two models which it discusses in the full report.) The question then becomes: can the industry supply this? On current trends, the answer is probably 'no'.
Here are some arguments why not (much more in the full note) and yes, ESG has a lot to do with it:
In recent years, investment in oil & gas field development has fallen sharply – from ~$740bn in 2014 to ~$475bn in 2019,according to data from Rystad (not including exploration spending). In 2020, it fell another 25% to ~$350bn.
This level is already consistent with the IEA's Net Zero scenario. The IEA has indicated that in its Net Zero scenario, oil demand will fall by 29% and natural gas demand by 7% by 2030, relative to 2019. As a result, it has also said that "there are no new oil and gas fields approved for development in this pathway". Under this scenario, the IEA estimates that oil prices will be around $35/bbl in 2030 and decline thereafter. The prospect of this scenario is a significant deterrent to invest.
Still, even though no new oil & gas fields need to be developed in the 'Net Zero' scenario, the IEA recognizes that some investment needs to take place in existing oil & gas fields (maintenance capex). As shown below, the IEA estimates the required level of investment at ~$365bn per year to 2030. With capex at $350bn in 2020, the industry is already investing for 'Net Zero'
Now it is true that 2020 was an unusual year in which many capex projects were put on hold because of covid-19. However, capex does not seem to be rebounding in 2021,and probably not even in 2022 either. Rystad Energy, which estimates capex based on visible project plans,estimates capex at $365bn in 2022 – up only marginally from 2020. The same can be seen in consensus estimates for listed oil companies. The relationship between oil prices and 12-month forward capex has practically broken (chart below left).
The chart below right shows consensus capex estimates for oil & gas companies by year. This suggests some recovery, but even by 2023, capex does not reach 2019 levels. To be clear, this latter chart shows all capex – not just upstream oil & gas capex. It also captures renewables capex from the oil majors, which is clearly rising. Underlying oil & gas capex appears distinctly flat.
So what will happen to global oil supply if capex stays flat at the 2020 level? Rystad's UCube allows for a detailed analysis of this, based on field-by-field data, including individual project break-evens. If capex remains around $350-360bn, oil production will still grow in 2022 and 2023, driven by projects that are already underway, but peak in 2024 and decline thereafter.
Here the Morgan Stanley commodity strategist is quite laconic: "Naturally, if supply peaks around mid decade and demand peaks only around the turn of the decade, this would create substantial tension in the oil market."
Translation: oil prices are going through the roof.
Arguably, the investment pressures discussed above are mostly applicable to publicly listed oil companies – perhaps government-owned oil companies, i.e. OPEC, can fill the gap? Perhaps – but there are two complications with this.
- First, despite indications from OPEC countries about capacity expansion plans, they are showing limited signs of accelerating such plans. As per Exhibit 29, the rig count in OPEC countries is still 40%+ below pre-covid levels and recovering even more slowly than in non-OPEC countries. Also,announced capacity expansions take time: Aramco has recently indicated that its planned 1 mb/d capacity expansion will only be realised by 2027.
- Second, if OPEC needs to fill the gap, its market share will rise, possibly quite sharply. This is indeed the case in the IEA's 'Net Zero' scenario, in which OPEC market share increases from ~37% recently to ~52% by 2050. Add Russia,and OPEC+ market share most likely exceeds 60%. The historical relationship between OPEC market share and the oil price is quite clear:as OPEC market share increases, oil prices usually rise.
With this in mind, Morgan Stanley expects that the tension in the oil market will need to be resolved via price (i.e., higher) ,and we raise our price forecasts substantially:
Short term - $95/bbl by1Q22, up from $77.5: At the moment, oil markets are objectively tight. So far this year, observable inventories have declined by ~450 million barrels – a draw rate of ~1.8 mb/d. MS expects this to persist for the remainder of 2021 and into the first part of 2022. As we argued above, oil prices disconnected from marginal production costs already some time ago. Instead, they are searching for the level at which demand destruction starts to kick in.
What this level is, is fiendishly difficult to know. However, Exhibit 30 and Exhibit 31 may give an indication. Here we show the dollar-value of oil consumption, expressed as a percentage of GDP (in other words, the oil burden on GDP) by region. At the global level, the oil burden on GDP would be ~3.6% if Brent were to remain at $84/bbl for a full year. That is still well below the level of 4.5% that prevailed during 2011-14.
This analysis suggests there could still be ~30% upside to oil prices before the oil burden reaches the average of 2011-14. However, there is broad dispersion across regions in this: For the developing economies in Asia (incl. China) and North America, it could be as high as 50%, but for Eastern Europe, South America and Africa,another 10-15% rise in oil prices would get it there. Another 10-15% rise in oil prices would drive Brent to ~$95/bbl, which is Morgan Stanley new forecasts for 1Q22.
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Long-term – $70/bbl, up from $60 (but much more likely to be $90 and possibly higher): Here MS defines 'long term' as the period starting in 2023 and stretching into the second half of the decade – it is not meant to reflect the period after 2030, which is an altogether different matter. Taking the thesis of this report to its logical conclusion would suggest that also by 2023/24, and beyond, oil prices will need to be at those 'demand destruction' levels - i.e. $85- 90/bbl, possibly higher. However, there is still a small-but-non-zero possibility that the scenario that kicked off this note plays out: that oil demand indeed falls sharply as decarbonsation efforts gain momentum and that this triggers a competition for market share amongst the major producers – i.e.as the window closes, the oil industry rushes to monetize its resources.
In this scenario, prices would probably be driven to very low levels, most likely close to the ~$35/bbl that the IEA estimates in Exhibit 24. But there is a very big "if" here - for this scenario to play out, important technological breakthroughs need to be made and/or more invasive government measures will need to be put in place (recall those trillions in QE that central banks will need to inject to get the Net Zero scenario on its feet - yeah, that) in order to realize the demand decline. At the same time, increased funding needs to emerge to finance this production expansion. As Morgan Stanley puts it, "that scenario appears unlikely, but it is possible nonetheless." The main use of the long-term price forecast is for equity valuation purposes. Therefore, it needs to reflect the weighted-average across all possible scenarios, not simply the scenario with the greatest likelihood. On balance, the bank raises its long-term forecast for Brent to $70/bbl,up from $60 before, while conceding that the most likely long-term price will be $85-90 "possibly higher."
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Medium term – $85/bbl, up from $75/bbl: The short term and the long term connect in 2022,and when they do so there may well be a wobble. Next year, US shale production will probably grow. Publicly-listed oil companies have barely added any rigs for the last 6 months, but privately owned E&P companies have increased activity materially. Therefore, production growth in 2022 will not look anything like the 2016-19 cycle in US shale, but should nevertheless expand by ~0.7 mb/d. In addition,a return to the JCPOA may unlock ~1 mb/d of additional exports from Iran. Also, OPEC still has spare capacity to unwind. Whilst the oil market is tight now and will be tight again in 2023/24, there may be a softer period in 2022.
The flipside to this forecast is that this expectation is relatively consensual, and there is much to offset it. Principally, OPEC will likely manage the market and keep the balance intact. The reason for this is that OPEC's market share is looking increasingly strong over the medium term. In the past, OPEC usually had to make a choice: support prices for the short term or defend market share for the long term. These tended to be mutually exclusive, but that is arguably no longer the case. Continued strong oil prices are evidently in OPEC's interest,also in 2022. However,at the moment, OPEC can keep the market tight without fearing a non-OPEC supply response. Therefore, MS suspects that OPEC will manage the market carefully during 2022, until market share will come its way in 2023/24.
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We strongly urge any readers who are invested in oil and/or commodities to carefully read the full note as it may transform their entire investing portfolio because if Morgan Stanley is right the price of oil is about to go much higher.