Insight Conversation: Christyan Malek, JP Morgan

Christyan Malek, JP Morgan's head of oil and gas spoke to S&P Global Platts associate editorial director, Paul Hickin, about oil price risk, the evolution of the US shale sector, and the outcomes of Saudi Arabia's strategy to balance the global oil market.

The risk of oil prices spiking above $100/b in the coming years has increased due to the impact of COVID-19 and likely ESG-climate change pressures on US shale, with longer-cycle upstream investments likely coming too late to plug a $650 billion capex shortfall, JP Morgan's head of oil and gas Christyan Malek told S&P Global Platts in an interview.

While the bank still sees $60/b oil as a long-term base case scenario, it turned bullish in 2020 after being long-time bears, warning of a potential oil supercycle by 2023 due to supply taking much longer to recover from the pandemic than demand.

"We do see oil prices massively overshooting and it won't behave in a 'Goldilocks' way and we see a nasty deficit appearing on the horizon kicking in earlier than many expect," Malek said, playing down the idea of any stability around a $60/b sweet spot and warning of the first annualized oil market deficit this year since 2017.

"While you have seen demand reset, we are going to see a lot of pent-up demand recover in the medium term, particularly the second half of this year, but the reality is it will be like a race to the bottom and supply is being diminished more than demand—it's not zero-sum," Malek pointed out on a call on Jan. 19.

JP Morgan has been calling this the great reset in the oil market, with 3 million b/d lost permanently in demand over the decade and more than 5 million b/d in supply lost by just 2025 compared to what would have likely returned. While the bank sees this deficit being recovered in the second half of the decade as oil prices move higher and encouraging fresh capital, there is a big danger it will come too late to prevent triple-digit crude prices without shale playing a similar role it has in the recent past.

The US Energy Information Administration's latest forecast is that US crude production will average 11.1 million b/d in 2021, down from 11.3 million b/d in 2020 and 12.3 million b/d in 2019. S&P Global Platts Analytics expects US production to decline further in 2021 and is circumspect over the speed of its recovery further out.

Whack-a-mole

Malek doesn't see shale responding as this 'whack-a-mole'—where every time prices go up oil production pops up somewhere—in the same way as the industry has to repair balance sheets and is focused on providing cash to investors who are highly disciplined on wanting to see returns over volumes this time around.

"COVID has been like the guillotine and laid a lot of production to rest and killed the shale whack-a-mole of oil the last few years and we have a cleaner supply and demand outlook, which is where the supercycle could kick in," Malek said.

He argues that it's about time shale "grows up" in terms of providing value to shareholders, highlighting that two-thirds of shale companies are owned by listed companies, and that there will be more pressure to be accountable in terms of ESG.

"The [Joe] Biden presidency will prove to be one of the most bullish factors in history for oil markets as it will put a glass ceiling on shale production in a way that it needs to, focusing on more disciplined cash flows as well as raising the marginal cost of production as you have to spend more on carbon sequestration, mitigating methane emissions, flaring etc.," Malek said. "The cost of production of that oil means you think twice before you drill."

Malek said that only when shale is on its knees and inventories are much lower will people start caring about longer-term production and non-OPEC and non-US supply such as Brazil, Mexico, Colombia and West Africa. It will be then that the capex shortfall comes into sharp focus and the many years it will take for the long-cycle capex to come back, he said.

Malek did concede that should oil prices sustainably recover quickly to, say, the $60/b-$70/b mark, that should help drive new production and bring in new capital; but he warned that the speed of its return is no foregone conclusion given the shifting policies around climate change goals and new commitments to ESG for oil majors.

Saudi box seat

The potential oil supercycle could hand the oil market keys to Saudi Arabia.

Malek said Saudi Arabia has been very smart in its OPEC policy, being much more short-term and dynamic, with hedging much more challenging because the market doesn't know whether it will raise or cut barrels.

"If US oil rig counts are up, OPEC will add barrels back into the market in April to cap shale productivity and it's not something we have recognized in Saudi policy as they have been largely in defense," Malek said.

"Saudis are the big winners from the supercycle; their share of demand growth goes from 15% in the last 20 years to 35%, because price war plus COVID obliterated the competition." Saudi Arabia could be in a position of strength to manage shale's recovery if this scenario plays out.

Malek said the OPEC+ meeting in April could be a turning point when Saudi Arabia switches from its unilateral 1 million b/d additional cut to extra volumes that is has instituted this year and that could actually signal the start of spare capacity falling to 2019 levels and the first steps towards a supercycle.

"Historically when OPEC has raised volumes, it's typically bullish for oil prices, because as they do that it's the point at which spare capacity inflects lower," Malek argued. While OPEC+ has a lot of spare capacity in the market with Saudi Arabia alone pumping 3 million-4 million b/d less than it can and others such as the UAE and Iraq adding extra capacity amid lower output, that could soon change once demand rebounds.

"The narrative in the second half of the year will be do we have enough spare capacity? And that is when the spotlight is on how shale at $60/b responds and also the spotlight finally returns to the non-OPEC non-US world and the supply crunch," Malek said.

According to Platts Analytics, OPEC spare capacity is near historical highs and will be around quadruple the 2 million b/d average for much of the past decade once the 1 million b/d additional cut from Saudi for February and March is factored in.

JP Morgan's research argues that while oil demand is expected to shrink in developed countries, emerging markets will remain a major driver of global demand growth through to 2030, with Malek adding that jet demand—the oil product most damaged by the pandemic—could show surprising resilience once the vaccine rolls out and things return to normal.

According to the research, the unequivocal oil demand message is that industrial and transport growth — including aviation, shipping and road -- in developing market economies (particularly those experiencing large demographic and population growth) into the next decade should not be underestimated.