As discussed in our prior blog, Midstream MLPs: What Just Happened? the fourth-quarter collapse in oil prices rivals the demand-driven collapse that occurred during the financial crisis as well as the supply-driven collapse of late 2014. However, today’s fundamentals appear to offer neither extreme.
Oil Demand and Supply Macro
To start, let’s compare the oil demand outlook of today versus that which gripped the market during the financial crisis.
During the financial crisis, global oil demand growth retraced from a 1.5% pace of growth to a -0.7% decline in 2008 and a -1.1% decline in 2009. This demand shock was spurred by wide-spread economic weakness as the impacts of the crisis seemed ubiquitous. Over the fourth quarter of 2008, U.S. GDP fell by a whopping 8.2%.
In contrast, for the third quarter of 2018, U.S. GDP grew at a 3.4% pace. While global economic activity does appear to be slowing, the prospects of a 2008-like global economic crisis appear remote. Further, oil demand growth for 2018 appears set to approximate 1.4 million barrels per day (mm bpd), or 1.4%. The “agencies” (IEA, EIA, OPEC) are forecasting similar demand growth in 2019 (ranging from 1.3-1.5 mm bpd). Though other “street” forecasts model a moderate slowdown, most still predict a generally healthy 1.0-1.3 mm bpd pace of oil demand growth.
In fact, instances of radical oil demand retracement are rare. In the last 30 years, global oil demand has turned negative only three times: twice during the financial crisis just described and amidst the collapse of the Soviet Union in 1993. During all other periods of economic slowdown, defined as periods where global GDP grew by 2.5% or less, global oil demand growth averaged 0.9%. Though many worry about the eventual impact of electric vehicles on oil demand, keep in mind that any related demand impact will necessarily be a very slow evolution and unlikely to serve as a “shock” to the supply and demand balance.
Looking forward, the International Energy Agency’s (IEA) New Policies Scenario (which assumes the adoption of additional government mandated carbon emissions policies to degrade hydrocarbon demand) anticipates a 7.5 mm bpd increase in oil demand between 2017 and 2025.
Let’s also consider today’s crude oil supply outlook versus the supply-fueled cyclical break in oil prices that began in the fourth quarter of 2014.
In late 2014, the oil markets awoke to the productive potential of U.S. shale. In the face of this new source of supply, OPEC nations flooded oil into the market in hopes of drowning out nascent shale drillers with a low price.
This market share battle ended when U.S. shale, through aggressive efficiency and productivity improvements, proved it was here to stay and OPEC finally cut supply in late 2016 to support pricing. In contrast, at the most recent OPEC meeting on December 6, 2018, OPEC members agreed to lower their production targets in order to maintain a healthier price.
More importantly, global oil and gas investment leading up to 2014 was robust with spending in 2014 reaching $700 billion. Conversely, global oil and gas investment has been very weak over the past few years. Spending dropped to approximately $400 billion annually since 2014 and is only expected to hit $425 billion for 20191; though, the recent collapse in oil prices may alter these plans.
In fact, today few global fields other than US shale are receiving enough investment to grow. The IEA estimates that global investment has fallen to a level that may place an unrealistic burden on US shale growth to meet global demand growth and to offset declines elsewhere1. Specifically, unless global investment increases from the current level, the IEA estimates that US tight liquids production would need to grow by 11 mm bpd between 2018 and 2025.
This level of supply growth is unprecedented and is roughly equivalent to adding another “Russia” to the global oil balance over the next seven years. Even if this level of US shale production growth is possible, clearly today’s oil price is simply insufficient to spur this level of investment. Cornerstone Analytics estimates that crude pricing must exceed $65 per barrel in order for annual U.S. production growth to even reach 1 mm bpd or more post 2019.
Clearly, while much attention is paid to the supply threat of US production growth, it is important to consider U.S. production growth in the context of global supply, demand and current inventory levels. In order to better gauge the health of the oil markets and take into account the consistent growth in oil consumption, observers often analyze inventories on a Days of Demand basis. Simply, this measures the number of days’ worth of crude oil demand currently stockpiled in developed nations.
OECD2 Inventory currently approximates 28 Days of Demand versus the 32 Days of Demand reached in early 2016 when oil prices dropped below $40 per barrel for a short period. In fact, 28 days represents a historically tight market. For context, when days-inventory touched a 20-year low of 27 days in the third quarter of 2013, oil was trading above $100 per barrel. Further, Raymond James currently estimates that inventory days could drop to 25 by the end of 2020 under the current path of global investment; which is well below the 20-year low of 27.
OECD Days of Consumption vs. Oil Prices (Inverted)
Sources IEA and Raymond James. As of 9/30/18.
When considering the fundamental backdrop discussed above, we feel comfortable suggesting today’s oil price level, and the resultant equity price turmoil, are unlikely to sustain. Even baking in a depressed $50 per bbl oil price, we note that one-year forward EV/EBITDA multiples for oil and gas producers sit below the historical average of 6x-8x. While the oilfield services sector remains marred by negative earnings revisions, even the multiples of the larger diversified players have compressed to a several turn discount to the average SPX multiple.3
Midstream MLP multiples are similarly extended at 7.3x versus a historical 10-year average of 11.0.x. Importantly, U.S. midstream volume growth appears relatively sheltered from price volatility as the primary threat to crude pricing is the low break-even economics of U.S. shale. In other words, despite near-term crude oil price volatility, U.S. volumes appear set to grow meaningfully. As a result, we believe midstream MLP volumes, the primary driver of midstream cash flows, to remain healthy.
- ^To help understand the potential impact of field declines, the IEA estimates that without offsetting investments, current fields would experience production declines aggregating to 45 mm bpd by 2025; which is approximately 45% of today’s global production.
- ^Source: Organisation for Economic Co-operation and Development is an intergovernmental economic organization with 36 member countries. Most OECD members are high-income economies and are regarded as developed countries. As of 2017, the OECD member states collectively comprised 62.2% of global nominal GDP.
- ^Source: Multiples data for E&Ps and OFS is coming from JPM research
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