The sharp decline in oil prices this year has been a headwind for the energy sector in our view. Oil prices are currently lower than they were when OPEC held its last meeting in November of last year. Sentiment towards the energy sector has turned negative resulting in weak stock performance across the energy sector except for the energy infrastructure which has held steady. Initially, traders were skeptical of OPEC's compliance with its production cut agreement. However, OPEC compliance has been a very good 99%, as of April 30, 2017. The biggest factor right now is U.S. crude oil inventories. In the first quarter, U.S crude oil inventories increased 12 out of 13 weeks including one of the largest crude oil inventory increases in U.S. history in February. We believe traders want evidence that oil inventories are declining and U.S. inventory numbers that come out weekly offer the most readily available information. The increases in U.S. oil inventories are not a surprise to us as the first quarter is a seasonal period when inventories typically rise.
U.S. Oil Production is Increasing
U.S. crude oil production is rising, with most of the increase coming from shale production. But think about this, U.S. shale oil production represents less than 5% of the total global oil supply. U.S. shale production is economic at $50 per barrel and in some basins U.S. shale oil is economic with oil in the $40s. However, we estimate that oil production from U.S. shale will likely increase by 300,000-500,000 barrels per day in 2017. Don't forget that global oil demand is forecasted to increase by approximately 1.4 million barrels per day in 2017.
A Battle for Global Market Share
Traders want to create a boxing match pitting U.S. shale versus OPEC in a battle for global market share, in our view. But we don’t think this is likely to happen, as the global oil markets are going to need both U.S. shale and OPEC to increase oil production for two reasons. First, global oil demand is growing by over 1 million barrels per day and the U.S. and OPEC are two of the lowest costs suppliers of crude oil. Second, we have only spent time so far talking about approximately 32 million barrels of production from OPEC and 9 million barrels of U.S. production, throw in Russia and we have only accounted for approximately half of global oil supply. Very few are talking about what is happening with the other half of the global oil supply. Capital investment related to the other half of the global oil supply which represents say 40-50 million barrels per day of production is expected to decline for the third consecutive year. Reservoir engineering and geology 101 tells us that oil production declines every year. If capital investment is insufficient to offset natural production declines then production volumes will fall. We believe the lack of capital investment in almost half of the global oil supply will result in declines in oil production, and that U.S. shale and OPEC will fill the gap created by the production shortfall associated with these declines in the years to come.
Extension of Production Cuts Could Remove Uncertainty
OPEC's production cut agreement is likely to be extended at the bi-annual OPEC meeting on May 25th in our view. All signals coming from the major players such as Russia and Saudi Arabia point to an extension of the agreement. While the production cut agreement would be likely be extended through the end of the year, some recent news organizations have reported that an extension of the cuts into 2018 is being discussed. This would be great news for oil prices. Regardless, the OPEC meeting should remove significant uncertainty from the current global oil markets. Second, we expect to see a consistent reduction in U.S. crude oil inventories very soon. We are entering the seasonal period when U.S. oil inventories decline most weeks. What is most encouraging to us is what has happened over the last 6 weeks in U.S. crude inventories. In 5 out of the last 6 weeks, the change in U.S. oil inventories was at or below the low end of the 5-year range. If this trend continues, there will be some substantial declines in U.S. inventories in the weeks to come. Look what happened yesterday! Another larger than expected inventory decline helped move oil prices up a little over 3%. So in general, we still believe that oil prices will range between $50 and $60 per barrel in 2017.
While the biggest factor impacting the entire energy sector right now is oil prices, what’s often overlooked is the energy sector is more than just oil. There’s also the oil pipelines, natural gas pipelines and natural gas liquids pipelines and other types of assets. These are steady, fee-based driven assets that are somewhat agnostic to oil and natural gas prices. Their cash flow and revenues and growth is derived primarily from volumes. We believe the U.S. energy sector is poised to become a critical long-term player in supporting global energy demand growth. As a result, we expect U.S. volume growth to occur in both oil and natural gas and midstream companies will play a critical role in providing infrastructure that connects areas of crude oil and natural gas supply to areas of crude oil and natural gas demand.
Energy: A Disruptive Technology
The U.S. energy sector serves a basic need and is critical to every sector. We are moving into a new era of low cost energy that could significantly boost global economic growth. The global energy landscape is changing. We believe shale oil and gas is here to stay. The U.S. is becoming a significant supplier of low cost energy to the rest of the world due to technology. A recent report by McKinsey labeled shale oil and gas as a disruptive technology. We agree. The U.S. energy sector is in transition requiring energy companies to be agile moving forward.