Stock markets, oil companies, service companies and investors are reeling from Saudi’s shock decision not to support a cut in OPEC production in order to balancesupply and support prices, and the consequent slump in oil prices.
This stance is a radical departure from Saudi’s previous behaviour when supply and demand fell modestly out of balance.
In the past, a few words of support have been enough to have the oil traders scurrying back to their desks to close their short positions.
Why the change of policy on this occasion?
There are plenty of theories, all of which are credible. A desire to arrest the inexorable growth in North American shale oil production? A conspiracy with President Obama to put further economic pressure on Russia to back off in the Ukraine?
A desire to reduce the funding of ISISby certain OPEC partners? It’s plausible that it may be a blend of all three.
The Saudi Oil minister Ali Naimi hasstudiously avoided providing any clues, but what he has said is that given that theaverage crude price for 2014 remains above $100, and the market is well supplied,there is no need for panic.
If only the oil traders had listened to him. With Saudi abandoning its historic $100/bbl “fair price for producers and consumers” rhetoric, and the next OPEC meeting not scheduled for another six months, traders took full advantage of the absence of visibility at which OPEC/Saudi will support prices, and drove the price down to $70/bbl.
Could they go lower? Yes, there is nothing to stop that (because the price is determined by paper and not physical contracts) other than technical charts that show that trading patterns suggest “resistance” (the point at which traders start to
get worried that there are more buyers than sellers) at $70/bbl.
It seems to be a crazy way to determine the price of the world’s “industrial oxygen” but if all the traders look at the same chart it becomes a self fulfilling prophecy.
How long will low prices endure? Simmons analysts have already identified 1.2million b/d of new production that was slated to come on stream in 2015 and 2016 that has been cancelled or postponed. Moreover there is no doubt that sub
$70 WTI will have a big negative impact on North American unconventional oil production, which has a relatively high break even point in cash flow terms.
There is no scientific answer to the “how long” question because we are in unchartered territory with respect to how quickly US unconventional production moderates.
Nor do we have a clear picture with respect to the demand side of the equation.
On demand, it’s clear that the speed at which US unconventional production has grown (1million b/d this year) is not the only contributing factor to the supply/demand imbalance.
Global oil demand growth in 2014 has been horribly weak, having been revised downwards by the IEA from an initial estimate of 1.4 millionb/d to just 680,000 b/d. This is a shock because in the last three years (when the economy has been perceived to be weaker than it is now), oil demand grew by 1 million b/d (2011), 1.1 million (2012) and 1.2 million (2013).
(The fall has been attributed largely to weakness in the Japanese and European economies in Q2 of 2014). Maybe it’s a blip, or inaccurate data, failing which it suggests that the global economic recovery may be faltering.
If that is the case we have a much bigger problem on our hands, (though clearly a significantly lower oil price will provide a tailwind to economic growth). Leaving that aside, the consensus of oil analysts is that the sharper the drop in price is, the bigger the bounce back will be, with most guesstimating this will be a 2016 event.
This thesis is supported by history which tells us that almost every year that oil prices collapsed, the following year they tended to snap back. Ali Naimi has been quoted as saying he believesthat the market will fall into balance in the second half of 2015.
Whilst the headlines focus on the plummeting prices, there is an important observation in the IEA’s November report that should not be ignored. They see supply risks as “extraordinarily elevated” due to the conflicts in Iran and Iraq aswell as the potential effects of social unrest that may ensue from the financial hardships that several countries endure because prices sit below break even levels.
Venezuela and Russia in particular are hurting -especially Russia as it is the effects of economic sanctions are biting. There is potential for events to turn nasty, just as they did thirty years ago when low oil prices led directly to the Mexican debt crisis and the end of the Soviet Union.
As is always the case, service companies will be put under the cosh. E&P spending budgets had already dialled in a new strategy that prioritises capital discipline and dividend payments over investment in chasing production growth, so a second cut will moderate spending still further. The resultant 15-20% reduction in capex budgets will fall most heavily on North American unconventional operations, the drilling and exploration segments, new projects that are on the cusp of kicking off,and of course projects that were already marginal at higher oil prices.
There is no doubt that inflation in certain parts of the service sector have grown excessively whilst most others are very cost efficient. Hopefully 2015 spending restraints will focus on moderating the areas of profligacy. All of the players would do well to heed the advice of Ali Naimi not to panic – after all, oil has averaged $100 /b in 2014 and it will likely return to the $85 – $115 range bound scenario of recent years when the confluence of an improving global economy and moderating supply growth is clearly in view.
In the meantime 2015 promises to be a period of great opportunity for those who believe that the positive prognosis for oil and gas in general, and oil services in particular, remains intact.
Colin Welsh is the chief executive of Simmons & Company International. He joined the company in 1999 to establish the firm’s Eastern Hemisphere business. Colin graduated from Aberdeen University where he studied economics, accountancy and law.