Bernstein: There is one reason to be bearish on crude oil, but ten reasons to be bullish.

The current crude oil market is in a highly divided state: extreme pessimism in consensus, but underlying fundamentals are brewing beneath the surface.

In the latest report, Bernstein bluntly points out that there is indeed a huge bearish reason in the market—oversupply. Weak demand from China, the lifting of OPEC production cuts, and strong growth in non-OPEC supply led to an increase of over 400 million barrels in oil inventories last year (>1 million barrels/day). As a result, market consensus has significantly lowered its oil price expectations for 2025, with some analysts even predicting Brent crude will fall to $61 per barrel in 2026.

However, this presents an opportunity for contrarian investors. Bernstein believes that while the market focuses on the short-term supply-demand imbalance, it ignores ten key pillars supporting long-term oil prices. For patient capital investors, the current price of $60-65 per barrel is unsustainable for the industry, as capital is fleeing, which often signals a cyclical bottom. As the old saying goes: low oil prices are the cure for low oil prices.

Return on capital has fallen below the cost of capital, making the industry unsustainable

At current oil prices, the industry’s return on capital employed (ROACE) has become alarmingly low.

Bernstein’s calculations show that the oil industry needs an average price of $50-55 per barrel to break even. If prices stay at $60 per barrel, the industry’s capital return will be only in the low single digits.

Looking back, in 2019 when oil was $64 per barrel, the return on capital was only 6%; in 2024, with an average price of $81 per barrel, the return reaches just 11%.

Considering the industry’s average capital return over the past 100 years is about 10%, the current low returns indicate capital is flowing out of the sector. According to cyclical investment manuals, when ROIC falls below the cost of capital and capital begins to exit, it’s the best time for investors to enter.

Long-term oil price expectations are below marginal production costs

Oil stocks reflect not current prices, but discounted cash flows based on long-term oil price expectations. Currently, the five-year forward price for Brent crude is $66 per barrel, which is too low for the industry.

Bernstein estimates the long-term marginal production cost at $71 per barrel. When prices are below long-term marginal costs, the probability of making positive returns from investing in oil stocks increases significantly.

This does not mean oil prices won’t be lower in the short term, but the odds are now tilted in favor of investors. Additionally, as metal and material prices rise, the marginal cost of production will only increase, not decrease.

China’s demand slowdown, but “Global South” will take over growth

The market generally believes that China’s “golden age” of oil demand is over: diesel demand has declined due to economic slowdown, and electric vehicles now account for 60% of total car sales.

However, Bernstein believes the story of global oil demand is not over.

While demand from OECD countries and China may peak, outside these regions, in the “Global South” countries (such as Southeast Asia, India, the Middle East, and Africa), with a population of 5 billion, per capita oil consumption is only a small fraction of Western levels.

The desire to improve living standards in these countries will drive energy consumption, becoming the new engine of oil demand growth over the next decade.

Idle capacity buffer is insufficient, risk premium should rise

Commercial oil companies are operating at full capacity every day, with the only buffer coming from OPEC’s “idle capacity.”

Although OPEC’s removal of 2 million barrels/day of production cuts last year caused oil prices to fall, it also increased effective idle capacity to 3.4% (over 3 million barrels/day).

This level has only returned to the historical average, roughly equivalent to Iran’s production. This means that in the face of unforeseen wars or supply disruptions, the global market’s cushion to absorb shocks is not thick. Therefore, oil prices should incorporate a higher risk premium.

Geopolitical risks are at multi-decade highs

History shows that Middle East wars often lead to oil price shocks.

Today’s geopolitical risk index is higher than at any time since 9/11. While this does not necessarily mean a major conflict is imminent, a more divided world undoubtedly increases the probability of supply disruptions.

Market optimism about Venezuela and Libya’s capacity recovery may be overly naive; the high geopolitical risk environment supports higher oil prices.

Weak dollar is a bullish factor for oil prices

Data from the past 30 years shows a strong negative correlation between the US dollar index (DXY) and actual oil prices.

A weak dollar not only benefits emerging markets as new demand drivers but also makes oil priced in non-dollar currencies cheaper, stimulating demand. As the dollar index shows signs of weakness, this is bullish for all commodities, including oil.

Reinvestment rates plummet, reserves’ lifespan shortens

Reserves lifespan is the best leading indicator of long-term production growth.

Over the past 25 years, the proven reserves lifespan of the top 50 global oil majors has fallen from 15 years to 11 years. The main reasons are low industry returns and companies focusing more on shareholder returns (buybacks and dividends) rather than capital expenditures.

The industry’s reinvestment rate (capital expenditure to cash flow ratio) has plummeted from nearly 100% to about 50%. This underinvestment will lead to weak future reserve replacement and exert downward pressure on future production growth.

The energy sector’s long-term underperformance offers contrarian investment value

The energy sector has only outperformed the S&P 500 in 3 of the past 11 years and has performed poorly for three consecutive years. The weight of energy stocks in the S&P 500 has fallen from 12% in 2011 to just 3% today.

Investor interest in this sector has hit rock bottom, but this is precisely the opportunity for contrarian investing. Oil tends to follow supercycles; while we may not be in a new supercycle, the sector could still see another major cyclical rally before demand peaks.

The golden age of US shale oil is ending

Over the past 15 years, US shale oil production exploded from 5.6 million barrels/day in 2010 to 13.5 million barrels/day, transforming the global landscape.

But this “golden age” is coming to an end. Major basins like Eagleford and Bakken have entered maturity, and even the core Permian Basin faces depletion in its prime zones, with signs of production plateauing.

Current consensus expects US crude oil production to remain near last year’s record levels. Drilling rig counts will continue to decline into 2025, and if WTI stays at $60 or below, rig counts will further decrease. This means the growth engine of non-OPEC supply has already stalled.

China’s Strategic Petroleum Reserve (SPR) buildup

Despite weak industrial demand, the purchase of strategic petroleum reserves (SPR) provides important support.

Last year, China added over 100 million barrels to its oil inventories, with another 150 million barrels expected to be added this year. Currently, China holds about 1.4 billion barrels of reserves, equivalent to 112 days of import coverage.

More importantly, the macro logic has shifted: China has large trade surplus funds. In the context of expensive gold (over $5,000/oz), oil becomes a better reserve asset. When oil prices are below $70, China has ample reason to continue strategic stockpiling of physical crude oil.

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Market has risks, investment should be cautious. This article does not constitute personal investment advice and does not consider individual users’ specific investment goals, financial situations, or needs. Users should consider whether any opinions, views, or conclusions herein are suitable for their particular circumstances. Invest accordingly at your own risk.