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Oil Price Sell-off Sparked by Transitory FactorsAugust  08,   2016

Spot oil prices have retraced $10 per barrel (bbl) since late June as the oversupply of crude oil has migrated into gasoline, theU.S. dollar (USD) strengthened post Brexit, and reports of Libya potentially restarting some of its exports emerged. Gasolineinventories have increased, causing refiners to reduce operating capacity while gasoline inventories are cleared, which should betemporary. USD strength has likely contributed to weakness in the commodity. The return of Libyan exports, if confirmed, has thepotential to shift the supply-demand balance by adding barrels into the market and could delay global rebalancing by one to twoquarters.

We view gasoline oversupply as transitory rather than a shift in global supply-demand balances. Gasoline refining margins werevery strong in 2015, causing refiners to shift yields toward gasoline. As the pace of demand growth slowed in 2016, partially dueto tougher comparisons, inventories rose while distillate inventories declined. Total U.S. petroleum inventories (crude + gasoline +distillate) are tracking closely with historical seasonal trends as distillate inventories make up for the slack in crude and gasoline.

In Libya, reports are emerging that oil export facilities may be opening up in the near future after being shut down sinceDecember 2014. It is unclear whether a deal between the fighting factions will be reached, but negotiations are underway. Someparties are said to be working toward a deal, while others indicated unwillingness to participate. We should know more in thecoming days and weeks.

The combined nameplate capacity of the shut-down Libyan oil terminals being discussed is 560,000 bbl per day (b/d),representing 0.5% of global supply. It is unlikely that capacity will be 100% operational given years of fighting, or what thecondition of the fields themselves will be. Research firm PIRA Energy Group believes that the base case is 300,000 b/d ofadditional supply coming to the market, if the factions can come to an agreement. In this case, the increase in the “call on theU.S.” to add production capacity can be delayed by roughly one quarter. This assumes no incremental step down in Venezuelan orNigerian production from here.

Outlook: Sub $50 Oil Cannot LastWe continue to believe that the industry cannot sustain sub-$50/bbl oil over the long run given negative industry cash flows,stretched national and private balance sheets, and lack of investment impacting production both in the U.S. (Exhibit 1) andglobally. Hence, we view the current sell-off as volatility on the rebalancing path. The energy industry used to spend $630 billionto keep up with trend demand growth of 1-1.5% (1 million b/d). Investment has dropped by 43% to about a $360 billion pace in2016 , which is already manifesting itself in production declines outside of OPEC (Exhibit 2). As the overhang of supply is workeddown, higher oil prices will be needed to drive investment back up.

 

Exhibit 1: U.S. Crude Production and Spending 

Source: Cowen, ClearBridge Investments estimates.

 

Assuming demand growth holds at more than 1 million b/d, U.S. production will need to start rising in 2017 and accelerate into2018, which is not possible with sub-$50 oil prices. Currently, non-OPEC production is falling and is likely to keep doing so attoday’s oil prices.

 

Exhibit 2: International Production and Spending 

Non-OPEC production excluding North America. Source: Cowen, ClearBridge Investments estimates.

 

Factors that can impact supply-demand balances to either prolong or shorten the downturn on the supply side include thesituation in Libya contrasted with the potential for disruption in Venezuela. On the demand side, we have not seen materialchanges to the forecast for global GDP or to the outlook for China. Growth in China is opaque and has been lackluster in recentyears, especially on the industrial side, but passenger auto sales growth has remained strong at 11% this year. We continue towatch China figures, which the International Energy Agency (IEA) recently revised slightly lower, but has offset with an increase inEuropean demand.

Dimitry Dayen, CFASenior Analyst - Energy15 Years experience  6 Years at ClearBridge

Past performance is no guarantee of future results.All opinions and data included in this commentary are as of August 4, 2016 and are subject to change. The opinions and views expressed herein are of DimitryDayen and may differ from other managers, or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results orinvestment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sourcesbelieved to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments nor its informationproviders are responsible for any damages or losses arising from any use of this information. 

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