The price of oil has absolutely crumbled over the past few months. Weaker than expected demand in Asia along with surging supplies from America have caused supply and demand to become imbalanced. That imbalance is only expected to grow with OPEC's decision to keep pumping oil. That said, this imbalance has happened plenty of times before, in both directions. However, the thing to keep in mind is that the overall cycle for oil is bullish for long-term investors because there remains two powerful forces still very much in play.
The demand story
While demand for oil is currently lower than had been expected, that trend isn't expected to continue forever. Lower oil prices tends to create more demand for oil. Further, population growth and expanding incomes from a rising middle class throughout the world is expected to fuel a 15% increase in oil demand by 2030 along with a 33% increase in demand for energy in general as noted on the following chart from an investor presentation by Chevron Corporation (CVX +1.65%).
Source: Chevron Corporation Investor Presentation
As demand for oil picks up it will eventually sop up the current oversupply in the marketplace. As that happens oil prices should begin to stabilize and likely head higher over time because of the other factor here, which is the supply side of the equation.
The supply story
While OPEC recently decided to stand firm and continue to oversupply the market, it will have a breaking point. However, it knows that others will have to break first given the breakeven cost for new oil supplies. In the following two charts we see that OPEC's oil is among the lowest cost oil supplies in the world.
Source: Chevron Corporation Investor Presentation
Because of the higher cost of other supplies we will see oil producers focused on those supplies cut back investments until supply and demand balance returns.
That balance shouldn't take too long to return because of the natural properties of an oil reservoir. As pressure is relieved from an oil reservoir the rate of oil production that comes from a well begins to decline. What this means is that there is a constant uphill battle to maintain a steady supply of oil because of the decline in production from a well, not to mention the fact that older wells deplete all together. Because of these factors oil producers constantly need to invest to bring new wells online just to maintain supply, with even more wells needed to meet demand growth. We see this in the chart on the following slide.
Source: Chevron Corporation Investor Presentation
As that slide notes the base production from mature oil fields will be in a steady state of decline, which will require $7-$10 trillion of additional investments by 2030 just to meet demand. Because of this, at some point oil prices will have to go up, or the cost of production will need to significantly drop, so that oil producers will be able to earn a high enough return on new wells to justify the investment required to meet demand.
Right now the oil market is oversupplied by about 1-1.5 million barrels of oil per day. Which, really isn't a lot considering that the world uses about 80 million barrels per day. This supply should be sopped up by new demand at some point in the future. However, at the same time, even without new demand, that oversupply can't really remain for too long because the natural decline rate of oil reservoirs alone will slowly drop supplies if investments aren't made to keep supplies steady.
Investor takeaway
These charts tell us one important story, which is that the current oil supply imbalance could potentially correct itself quite rapidly. Given the outlook for future demand growth when combined with the uphill battle just to keep supplies flowing, oil prices have the potential to correct higher at the first hint that supply and demand is heading back into balance. That's why investors need to avoid freaking out over oil prices because those prices have the potential to reverse just as quickly in the future.
