Things will get better because they can’t get worse. We’re at or near the bottom. Better times ahead.
But you’d never know that based on oil prices or the news. WTI dropped more than 3 percent on August 11, hovering near prices not seen for more than six years, since the dark days of 2009. The commentary is universally bearish. Everyone from analysts to oil company CEOs are saying what you see is what you get for the foreseeable future. Comparisons to the great price collapse of 1986 and the 15-year nuclear winter that followed are again making headlines. It’s not awful; it’s worse.
Numerous challenges exist. Every day there’s yet another reason why oil prices will never increase or economic conditions improve. Iran. China. Greece. Global inventories. OPEC overproduction. Rising North American rig counts. Carbon taxes. Corporate tax increases. Royalty reviews. No pipelines. The news is so depressing, more are saying this downturn is the worst ever, although there is significant evidence to the contrary.
This is not new. What the industry has always done is extrapolate; whatever happened yesterday will continue. If things are good, they always will be. If it is bad, it will remain so forever. After 36 years of writing about the always-volatile oilpatch, the only constant is the herd is usually wrong, regardless of the direction it is headed.
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There are two buckets of information essential to reaching a reasoned independent analysis. Bad news first.
• The modern oil industry has never operated without Saudi Arabian or OPEC supply management. When prices went too low, the Saudis would always withdraw output to stabilize markets. In 1986, the Saudis shut in over 5 million barrels per day to get crude back to US$18. Today the Saudis claim to seek market share, not price. OPEC production in July was reported at 31.5 million barrels per day (b/d), 1.5 million above its June 5 quota of 30 million b/d. This is about 2.3 million b/d above stated OPEC internal demand for 2015. The specter of Iran increasing production, if its nuclear inspection agreement is ratified, weighs heavily on market sentiment.
• Commodity prices as a group – oil, potash, iron ore, coffee, and copper – are at lows unseen since early this century. This is made worse by a strong U.S. dollar. Hedge funds specializing in commodities are losing money and shrinking as profits become more elusive. The futures market for oil is very bearish. WTI five years out for September 2020 was only US$61.80 on August 7, reflecting the fact that nobody figures the price of oil is going anywhere and no speculative investors are taking risks.
• Future oil demand is in doubt for three reasons.
1. China, the world’s second largest economy, has serious financial problems, the long-term impact of which are as yet, unknown. For years, the mantra was China’s growth would power demand for oil and other commodities. The party is over. China’s stock market problems are in the news, while enormous and unsustainable internal debt should be.
2. Governments in most western countries unquestioningly link oil consumption with climate change and are taking steps to ensure consumers use less. We’re told daily the future of mankind depends on using less oil.
3. Western government economic stimulus via near-zero interest rates and quantitative easing have run their course and can no longer stimulate meaningful economic growth. This affects commodity demand and price.
• The replacement cost of tomorrow’s barrels seems unknown. Current production is thought to be impervious to price. Because of legacy investments, output is rising in the oilsands and the Gulf of Mexico. Very little oil has been shut in because cash operating costs are at or below current prices. Thanks to aggressive drilling, Saudi Arabia is able to sustain record output (123 rigs drilling in July 2015, up 50 percent from July 2012 according to Baker Hughes (NYSE:BHI)). Based on bad data or miraculous geology, U.S. shale output is reported to still be rising despite a 60 percent reduction in the number of rigs drilling for oil. The Baker Hughes U.S. oil drilling rig count was up only 52 rigs to 670 on August 7 from a multi-year low. Yet somehow this is proof U.S. shale production will not experience any material declines soon.
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• The Canadian political climate is depressing but hopefully not hazardous. Alberta’s 20 percent corporate tax increase on July 1 resulted in over $1.3 billion in Q2 book losses by only three large producers; Canadian Natural Resources Limited (TO:CNQ), Imperial Oil Limited (TO:IMO) and Suncor Energy Inc (NYSE:SU). Billions more will follow. While the losses are largely non-cash for now, the optics are awful. The federal election has opposition parties claiming a lack of carbon taxes and environmental protection legislation are the reasons no pipelines have been approved. In Alberta, the outcome of the pending royalty review and a new environmental policy appropriate for a 21st century NDP government are not confidence builders.
Hide the sharp objects. This is a big batch of misery for today’s battered oilpatch. But there are also some positive aspects.
• With the exception of oilsands mines, all reservoirs yield less oil tomorrow than today. Typical decline rates for the best conventional reservoirs is 3 to 5 percent per year and the output of most shale oil wells falls 50 percent or more in the first year. At 4 percent globally, this is 3.8 million b/d at current world oil production of 96 million b/d. Announced capital expenditure cuts are estimated at US$180 billion over the next few years. This will have a meaningful impact on future supplies. The International Energy Agency (IEA) estimates average annual investment on new crude output from 2010 to 2013 was US$320 billion. If the recent Capex cuts are over three years, it equates to an annual investment decline of about 20 percent; this rises to 50 percent if the cutbacks occur over the next 15 months. Regardless of why current output remains high, the global oil and supply demand curves simply must and will cross in the not-to-distant future.
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• Comparisons of the current situation to the mid-1980s remain ludicrous. When oil prices collapsed in 1986 and remained low in real terms for 15 years, world oil supply exceeded demand by about 14 million b/d. This was nearly 25 percent of world demand of 60 million b/d. The current surplus of supply over demand is about 3 million b/d, or 3 percent. The IEA reports Q2 production was 96 million b/d but demand will reach 95 million b/d in Q4 of this year and 96.4 million b/d in Q4 2016. Depending on production increases, the surplus will fall to 1 million b/d then zero. This is nothing like the situation in the mid-1980s and to suggest otherwise is uniformed and irresponsible.
• Rig counts are rising in the U.S. and Canada because they must. The rise is not meaningful compared to historic levels but are a reminder of several factors: oil companies must drill to stay in business, cost and technical efficiencies always emerge when they become essential, and every reservoir and the economics of its development are different. In the U.S., how putting 42 of 981 laid down drilling rigs back to work will sustain or increase 4 million b/d of shale oil production is difficult to conceive.
• Canada is the fifth-largest hydrocarbon producing jurisdiction in the world, on a barrel of oil equivalent basis. The oil industry is a major driver of the Canadian economy and a big reason why North America remains a global economic island in terms of its long-term energy costs. People will figure this out, including voters in the October 19 federal election.
• The next market turn will be dramatic and it will be up because it can’t go down. The current mantra is, for the first time in recent history and without supply management (see above), somehow crude oil is the only commodity that will trade in a narrow and predictable band when supply and demand reach equilibrium. Every other commodity without the supply management that oil has enjoyed for over four decades is very volatile.
There is likely no good news in the short term, the next couple of months, that is. Prices may go lower again based on market sentiment. Keep the faith.
In the medium term—the next six months, hopefully—there will be growing stability and confidence if federal and provincial politicians don’t do anything really awful.
But the long term looks good. The herd is wrong again and global oil supply and demand will prove it.