Even for the traditionally volatile oil patch, the last two-plus years have been startling to behold. The price for WTI crude fell into negative territory at the depths of the pandemic, only to soar back to the $80s post-reopening and then up to $130 per barrel with the Ukraine conflict. More recently, oil has hovered around $100 as monetary tightening and recession concerns weigh on price.

In our view, what happens from here is a major question. Demand has benefited as Americans have sought to return to normal this year, taking long-awaited vacations despite $5 per gallon gasoline. Even with higher prices, gasoline demand has been fairly steady at 9 million barrels per day, which is in line with last year, albeit still about 8% below 2019 levels. Globally, demand signals have been more mixed, with COVID lockdowns in China offsetting a rebound in developed nations’ consumption coming out of the pandemic.

Regardless of where demand goes, the supply picture looks challenged, exacerbated by the Russia/Ukraine conflict. As we see it, there are three “relief valves” in the oil market today:

One is the OPEC+ consortium, which is getting the most attention as President Biden encourages the Saudis and others to produce more oil. Unfortunately, it’s not that easy. OPEC+ reduced output by about 10 million barrels per day in 2020, and member states have struggled to reboot idle facilities to meet rising production quotas, let alone make up for the prospect of reduced exports from Russia (one of its members). Even if U.S. diplomacy proves successful, potential for additional output from OPEC+ is probably limited at best.

The second is U.S. shale producers, but we are not forecasting an acceleration in growth beyond the current plans that they have detailed. This reluctance to spend and drill more goes back to the early 2010s, when many shale companies simply plowed their profits back into new production, a bet that turned bad when oil prices later collapsed. Since then, the survivors have typically adopted a capital discipline mantra, opting to turn over much of their current earnings to shareholders rather than reinvest (see display). Today, we are seeing little eagerness to pivot back to a growth model, especially given commitments made to shareholders, inflationary pressures (labor, materials), limited service-company capacity, regulatory constraints and longer-term trends around decarbonization. In our view, maintaining discipline is good for the stocks of these companies, but maybe not for the inflationary environment.

Oil Producers Get Religion

U.S. Public E&P Reinvestment Rates as % of Cash Flow

Source: Morgan Stanley, as of March 2022. E&P is exploration and production. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

Finally, the third relief valve is demand destruction, which based on recent oil price weakness may be the most likely path out of current tight conditions. In essence, the toll of high prices may prove too severe to avoid changing consumer behavior or curtailing business consumption. In the U.S. and other developed nations, we may be starting to see signs of price-related shifts in traffic volumes, which have probably contributed to recent oil price declines. Whether this turns into a major trend should become apparent as we move through summer and into fall.