Commodities | 11:00 AM
Global oil markets are preparing for over-supply, but when it comes to oil, is anything ever set in stone?
By Christian Floro, Market Strategist, at Principal Asset Management
Headlines in the oil and gas markets have caused a stir as investors debate the future direction of oil prices and related equities.
Yet, despite much at stake, recent geopolitical flashpoints—including the 12-day armed conflict between Israel and Iran—have done little to make a lasting mark on energy markets.
Instead, continuing to exert itself are fundamental supply and demand factors, which point to a slightly unfavourable market dynamic for oil.
As a result, to the extent geopolitical noise continues to subside in the near-term, a bearish trajectory for oil prices is likely to increasingly emerge.
An incoming supply glut
The oil market looks to be sliding into oversupply, but the outlook is anything but straightforward.
Several supply-side dynamics will shape the path ahead, including the lingering effects of OPEC-plus production cuts, how U.S. shale producers react to price swings, and the impact of sanctions on exporters like Russia, Iran, and Venezuela.
Each of these forces could either tighten or loosen conditions, leaving the market’s next chapter far from settled.
OPEC-plus announced a series of production cuts to balance the market, beginning with collective cuts in October 2022, followed by additional voluntary cuts in April 2023 and November 2023.
However, the group has since started to reverse these production cuts, with approximately 2.2 million barrels of oil per day being released back into the market through September of this year.
As a complete unwinding of these production cuts is likely to have a meaningful impact on the balance of supply in the energy market, OPEC has pursued a gradual and flexible approach to normalizing production.
Looking ahead, it’s likely the cartel will remain united in this approach, pursuing their goal of regaining lost market share over the last decade while simultaneously making sure that prices do not decline too much in the process.
Combined, this will likely act as a tailwind for oil supply in 2025 and 2026.
U.S. shale production
Over the past decade, U.S. oil production has doubled, driven largely by the shale revolution, which now accounts for nearly 80% of total output.
Unlike conventional production methods that demand heavy, long-term capital commitments to generate output for a decade or more, shale operates on shorter investment and production cycles.
This flexibility allows shale producers to respond quickly to market signals, scaling back when prices fall and removing excess capacity with relative ease.
The ability of shale producers to quickly scale back production may be more limited in today’s environment. Many operators are now prioritizing capital discipline, leading to steadier production growth and an end to the double-digit swings seen in prior years.
In addition, oil prices would need to fall much further to trigger a supply response. The Dallas Fed Energy Survey estimates that while the average oil price needed to profitably drill a new well is around US$65/bbl, the average price needed to cover operating expenses for an existing well is lower at around US$40/bbl.
This implies that prices need to fall closer to US$40/bbl for producers to be incentivized to cut production. With average prices year-to-date hovering near US$67/bbl, U.S. oil production is likely to level off, rather than fall outright.
Since shale is no longer acting as the marginal producer and with declines in production unlikely, supply will likely remain relatively elevated compared to market expectations.
Potential sanctions
Finally, the possibility of sanctions on production—particularly on Iran, Russia, and Venezuela, all of which accounted for 13% of global supply in 2024—is an important wildcard that could potentially offset excess supply elsewhere.
One of the biggest potential swing factors for oil markets is the prospect of new sanctions on Russian crude as the U.S. seeks to end the Russia-Ukraine war.
A bipartisan bill proposing tariffs of up to 500% on countries purchasing Russian energy had been gaining traction in Congress but was recently put on hold.
In addition, President Trump has floated the idea of secondary sanctions, which would impose tariffs of roughly 100% on countries buying Russian oil in an effort to accelerate a peace deal with Ukraine.
Either measure would pose a major risk to global oil supply, given that Russia is the world’s third-largest producer after the U.S. and Saudi Arabia.
For now, however, the likelihood of these sanctions being fully enacted remains low, as the disruption would be severe.
This means sanctions should be viewed more as a tail risk than a base case. In the meantime, supply from the U.S. and OPEC is still skewed to the upside, raising the possibility of oversupply if demand growth softens.
Global demand is being challenged
While forecasting global oil demand always carries some uncertainty, a consensus consisting of the IEA, EIA, and OPEC suggests energy demand is likely to only grow modestly this year, to the tune of around 1 million barrels per day.
This is a notable downshift from 2023 or 2024, which saw demand growth of around 1.5 to 2 million barrels a day. The softer outlook is driven largely by Asia, particularly China, where ongoing economic malaise and the increased adoption of electric and hybrid vehicles are curbing demand.
With China accounting for nearly 50% of annual growth in oil consumption in recent history, trade tariff policy between the U.S. and China also poses a headwind.
While tail risks have been avoided (the de facto trade embargo with the U.S. is no longer a likelihood), elevated tariffs on Chinese goods imply a potential deceleration of industrial activity, which could weigh on energy demand.
The spillover of the U.S. trade wars may also act as a headwind to global growth, adding downside risks to energy demand.
Implications for investors
The current supply-demand balance suggests that risks are skewed toward a somewhat unfavourable backdrop for oil, with prices biased lower if geopolitical noise around sanctions or Middle East tensions fades.
Yet the implications are unlikely to be uniform across the energy complex.
In a weaker oil price environment, companies with less sensitivity to commodity prices, those able to defend margins and grow cash flow through efficiency gains or cost reductions, are better positioned to outperform than higher “oil-beta” peers.
At the same time, structural forces within the sector remain important. Oil and gas are set to play a central role in the global economy for decades to come, even as the energy transition progresses, leaving room for growth in natural gas and LNG markets.
Finally, there is an oft-quoted phrase in commodities that “higher prices fix high prices,” and it works just as well for low prices.
Investors should remember that commodity markets are inherently cyclical: lower prices can sow the seeds for higher prices by discouraging investment and tightening supply.
While the near-term outlook tilts bearish, the long-term picture still points to oil markets that remain volatile, cyclical, and rich with opportunities for selective investors.
Re-published with permission. Views expressed are not by association FNArena’s.
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