Over the past few months, all asset classes have witnessed a marked pickup in volatility. Nearly every day, headlines tell an apocalyptic story about a country, market or company – and the wild ride in commodities is frequently a focus. Yet over the past six weeks, Brent crude oil has been remarkably stable, holding steady at the price that served as a floor in January and for most of July. We expect firmer prices ahead, with Brent rising about 20% from today’s level to about $60/barrel in 2016.
The chief reason for the optimistic outlook, albeit guarded, is that with Brent trading below $50/barrel and West Texas Intermediate below $45/barrel, the forward supply outlook is materially and adversely affected. Over the past two months, there have been increasing signs that U.S. and Canadian production is turning lower. While stepped up output in the Gulf of Mexico has supported overall U.S. output, U.S. onshore crude oil, primarily shale, has declined for four straight months. Canadian conventional crude oil production has also been declining sharply the past nine months, enough to nearly offset growth in oil sands output.
In addition, global demand has grown strongly, in part due to low oil prices that encouraged robust growth in demand for transportation fuel. Demand strength, in fact, has been the biggest surprise in the market this year – not the resilience of U.S. supplies. This combination of strong demand and slowing supply has reduced the likelihood of the doomsday scenario where stocks breach storage capacity and prices need to fall significantly to cause producers to shut down producing wells.
With producers facing tightening financing conditions, particularly relative to the first quarter when investors rushed in to the market, the forward production outlook in North America and globally is further diminished. Assuming demand growth of roughly 1.25 million barrels/day next year, slightly above trend growth, we expect prices in 2016 will need to improve to about $60/barrel, the point at which drilling can once again resume and deficits are avoided in subsequent years.