This post is a follow-up of our November comments on OPEC thinking and market strategy. We pointed to the need for oil prices to go significantly below 80 USD/Bbl (Brent) to restore market balance, i.e. reduce the flow from competing sources such as US shale oil. While applications for drilling permits in the US are estimated to have fallen by 38%, no price floor is yet apparent at the current price of 60 USD/Bbl (23 December 2014).
Our discussions with many in the industry have highlighted shock and confusion, but also optimistic pragmatism. Fundamentally the unresolved state is disturbing for all but the most financially robust players. The depth and duration of low oil prices is pondered across the industry, and we here discuss the abysses and our view that the deepest fall can and should be avoided.
The apparent permanence of 100+ USD/Bbl in recent years brought many oil companies and investors to raise their previous investment thresholds from 70-75 USD/Bbl. Seeing cash flow reduced, a number of oil companies are planning to slash 2015 activity by around 20%, which seems predicated on conventional wisdom and an expectation of a return to a 70-80 USD/Bbl price range. Certainly, much lower scenarios are being evaluated, 40% or more, with corresponding deeper spending cuts.
This note discusses new factors and our expectation that the average 2015 oil price could be significantly lower than conventional expectations. The key question is how low the price can or must go, and for how long, to restore market balance. We believe as low as 35 USD/Bbl.
For the past five years we have rhetorically stated that at 100 $/Bbl, oil supply will in the long term be infinite, while demand will be zero. Oil has dramatically lost its market hold after ten years of very high oil prices. Also influenced by climate crisis, the world seems to be irreversibly shifting away from fossil fuels, in policy, in popular opinion, and most importantly, in terms of technology. Conventional wisdom says that the transition will take decades. We may, however, see a critical mass of changes already affecting prices.
Famous Goldman Sachs analyst Murti asked in 2005 what oil price it would take to stop Chinese economic growth, and his answer was 105 USD/Bbl. We know now that this was the wrong question, but the right answer, if the question had been posed in a global perspective. Even the IEA is slowly revising demand forecasts down, and more will come. Overestimated demand is the new surprise, giving weakened guidance to exploration planning.
The stark reality is that 100+ USD/Bbl induces fuel switching and technology-developement, and is way above a market-clearing price. This is unless we are in a super-growth period, which Japan saw in the 1960’s, South Korea 20 years later, and China 20 years after that. Can we now hope for such growth for India and Africa? We think, not enough. While the producer cash flows have been fantastic in recent years, producers – and certainly OPEC – should accept that super-growth and very high oil prices are cyclical and not sustainable.
This brings us to our fundamental thesis that oil markets are balanced at about 60-70 USD/Bbl, but can be driven up or down by 50% due to demand variations, overshooting or undershooting, of as little as 1-2% in either direction. Energy Perspectives believe that oil prices are now fundamentally defined between 35 to 105 USD/Bbl, with few and in recent years weakened intermediate support levels. This has deep implications for oil company financial risk management, but also the ability of discretionary producers, such as key OPEC members, to effectively steer prices.
Key in our analysis is the observation that recent years have brought irreversible changes to underlying energy use technologies and preferences. While oil is certainly still a priority product, its usage has gradually been undermined by several developments.
In economics a “Giffen good” is a product that is consumed less with increased disposable income. This means often that it is a necessity, but not desirable. In the past, the rule of thumb has been that for any percentage increase in income, oil consumption has increased with the same amount. This rule has now been broken, and the oil to GDP ratio is dropping. For the incremental GDP, incremental oil usage is very low, in some cases negative. Oil is a necessity, but at high prices certainly not desirable.
New and improved technology has emerged in recent years that dramatically reduces specific fuel consumption. The Giffen effect is conventionally used in categorizing consumables, such as potatoes. It appears in oil when increased disposable income allows the replacement of old, inefficient technology with much more efficient new technology. The replacement may not only be to a more efficient oil-based model, but completely out of oil.
In the past decades, oil has gradually lost market share in most segments, starting with high-sulphur residual oil for power and heat generation. Residual oil is now mainly used as cracking feedstock in refineries. Similarly, gasoil for heating has largely lost market to natural gas and district heating in key markets, recently also to electric heat pumps.
Even the transportation sector, the ultimate stronghold of oil, suffers from a combination of a 35% increase in new car mileage since 2007, and increased urbanization and concentration of residence, leading to less need for local transport. As disposable income rises from economic growth and lower oil prices, much more efficient new vehicles replace old vehicles.
Oil is now predominantly used in transportation where there is very little price elasticity of demand. With the loss of market in the heating and power sectors, there is simply little left of the old infrastructure that could be brought back on-line as oil prices now fall. The classic energy demand curves have therefore lost major previously price-supporting oil elements. As flexible, low-tech steam coal power plants have been phased out, even this rock-bottom segment offers little price support for oil.
The recent seemingly bottomless fall of oil prices is directly related to Giffen factors having built momentum over a period of time. Increased supply and reduced demand now expose that there has been a major creeping, but accelerating loss of price-supporting thesholds. Looking forward, we must reassess old rules of thumb and how deeply underlying, creeping changes have taken hold.
The market fundamentals of 2014 are therefore radically different from 1986 when last a dramatic rise in competing production, then from the North Sea, undermined OPEC’s market share. It turned out at that time to be impossible for OPEC to stop new source oil production with market share and volume strategies. Prices slumped for fifteen years. US shale oil production has now risen to the same level as North Sea oil production in 1986. Yet, volume strategy may now actually work if the guiding long term target is reasonable, such as 70 USD/BBl.
The result of the creeping demand-side changes is that most of the burden of restoring oil market imbalance in fact now has to come on the supply-side. With OPEC production unchanged, and including previously removed volumes from Libya and Iraq, adjustment will have to come from the remaining two thirds of global supply. OPEC’s intent to “let the market adjust” is therefore a strongly competitive near-term market-share statement, tantamount to dictating production reduction by other suppliers.
High prices have supported increasing supply from both conventional sources and from unconventional sources, such as shale. While OPEC may have felt quite comfortable with high-cost new exploration supporting oil prices, the radically declining costs of shale oil exploration has undermined this in just three years. However, company projections show that shale oil is within 15% of realizing its efficiency improvement potential, and unit costs will rise as sweet spots are depleted. Conventional wisdom has now reached shale as well.
The question is if OPEC, and other discretionary producers, are also positively aware of their new power. We think that OPEC, and other discretionary producers, may (again) consider a much more organized and dynamic approach to volume management. If not, a “smooth landing” is unlikely and a significant price volatility must be expected. This is accentuated by the fact that a near-term response from some producers, even within OPEC, may be to attempt to increase production to maintain cash-flow.
Given the depth of the market changes, it is possible that OPEC and other producers do not fully understand the implications and assumptions of their strategies, expected bahaviors and importance of their roles. Other than managed, discretionary production level adjustments, which OPEC has stated it will not do now, the supply-side reacts very slowly to oil price changes. The announcement of major shale oil company spending cuts may stem downward pressure, but fundamental market data is now so strong that the support would wane quickly unless quickly matched by measured output reduction.
The price slide may therefore renew and persist well into the new year. Effective coal parity, or gas parity in the US, will only be reached at about 35 USD/Bbl (Brent), where significant demand-side response may be triggered. This is also the level that oil prices briefly fell to following the 2008 financial crisis. Fundamental price support is weakened even at this level compared to 2008. Prices may therefore even fall below 35 USD/Bbl for a time.
From a producer perspective, this is not only a worst-case scenario, but also a quite likely outcome if OPEC maintains its market share strategy, and supply adjustment is slow from other sources. Certainly, even the lowest cost “sweet spot” shale oil producers in the US, such as EOG Resources, will be barely full-cost profitable at 35 USD/Bbl. As detailed shale resource maps show, they are in the best 15% range of resources, with well productivity 3x the average. The top 5 shale oil producers represent about 1/3 of production, have very few “dogs” and are far from meeting variable cost limits.
Other producers, including those with heavy oil and oil sands production, meet reinvestment and variable cost limits far earlier. Their ratio of well “stars” to “dogs” is much weaker than the top 5 and their adjustment to price changes will be critical. There are few pure “dogs”, since these wells have typically not been completed. This means that 2/3 of unconventional oil production is at risk, with a nearly linear distribution of full-costs. Variable costs are much more diverse, but shale wells are typically not exposed to low oil prices.
From past experiences, the duration of price falls may be everything from a few months to several years. In our assessment, the current “core” supply overhang is on the order of 1.5-2.0 million Bbl/day. The current market-balancing price level is around 70 USD/Bbl, but the volume overhang requires a much lower price for quick adjustment. Quick adjustment can only be realized if other producers also take the signal of OPEC’s intent and that a new marker price, a lower balancing price, is defined.
Even if shale oil production is relatively quick-adjusting, with an average 1.0-1.5x annual reinvestment cycle, it is at least 10x slower than the now lost price sensitive oil demand of the past. Barring a very cold northern hemisphere winter and a surprising increase in transportation demand, without other factors it may take more than a year to eliminate the supply surplus. The oil price could in the interim be very low for 3-6 months, in the extreme even below 35 USD/Bbl. A slow response from shale oil producers can force OPEC to continue a volume strategy.
Based on the current volatility range and market-based, supply-side adjustment alone, the average price for 2015 could be well below 60 USD/Bbl. A second round of oil company activity reductions, far deeper than currently announced, could therefore be expected by Q1 2015. Such an outlook is certainly uncomfortable for the industry at large, but also OPEC.
As in the past, there may again be a role for OPEC and non-OPEC producers, such as Norway, to discuss joint temporary adjustments in output. However, it is difficult to foresee a coordination involving 100+ US shale oil producers, even the top 20, not at least philosophically. Here, the “invisible hand” of the market must work. Early signs of shale oil production stagnation could possibly lower this obstacle and motivate initiatives even ahead of the next OPEC meeting.
Right now, OPEC and the rest of the world is waiting to see what is happening in the US, but solid data is unlikely to appear until well into January, possibly the end of Q1 2015. For the oil industry, the end of 2014 and early 2015 is therefore not likely to be pleasant. However, there may be comfort in that, in a global perspective, the volume adjustments required to reestablish market balance are relatively small.
Market confidence has been restored before and the current price path and turbulence is not good for any long-term oil player. It is now not just a question of leaving it to the market; more than in decades it is again a question of leadership, and how OPEC and non-OPEC producers will respond.