Despite widespread assumptions: the world is not facing years of low oil prices. In fact, the oil price is about to rise again, and we expect the rise to be significant and long lasting. Investors should take note, and governments need to prepare themselves for the positive and negative consequences
As we argued strongly in our piece about the December OPEC meeting (December OPEC meet) the oil price will rise this year. The current oil price assessments in the media are, we believe, incorrect and based on an assumption that what happened before will continue to happen; it is poor logic in our view. As the oil price falls, traders and analysts have become almost hysterical in publicly speculating how low oil can go and how long it will stay low, while leaving unconsidered the possibility that the price decline, because of its effect on investment, might actually contain the seeds of its own destruction. We predict that after summer the price decline will be reversed, with prices spiking in Q3 and Q4 2016.
Tales of oil gluts and price crashes dominate the media. At the heart of this discourse is the assumption that Iranian oil’s return to international markets will further undermine the oil price, and that American oil companies will continue to borrow and find efficiencies to maintain production, as they have so far. Financial giants such as Goldman Sachs are suggesting that prices will hit the $20 mark, and leading oil traders are suggesting a decade of low prices. At the same time, China’s economy is struggling, hitting future demand forecasts. The lifting of sanctions last month (January 2016) against Iran has leant further support to this negative sentiment, as all await the new, even larger, oil glut. Demand worries and overproduction are not a good combination for optimism. The picture in the US Commodities Futures Trading Commission report is even bleaker. Speculators (investment funds, private equity, banks) have all gone short, with positions increasing by around 15-18 percent over the past week, reaching historic levels. Iran, according to Iranian Deputy Minister of Petroleum, Amir Hossein Zamaninia, is aiming for an export increase of 500,000 bpd over the next few months, which explains at least some of the increase in short trades.
But this assumption is based on superficial analysis. The main underlying oil sector fundamentals are actually indicating the opposite. Analysts and investors need to think the unthinkable, that 2016 will see a serious and sustained increase in the oil price. If the underlying financial and operational dynamics play out, the global oil market is heading for a new oil price spike. With the world economy stumbling, the consequences of such a spike are hard to predict, but likely to be negative for oil importing countries. This paper argues the need to reassess widely held economic assumptions and start to examine the growing underlying market discrepancies which we believe will lead to the rapid elimination of the oil oversupply and the creation of new oil shortages in 2016. All this will occur without OPEC coordination to reduce supply.
Oil market bearish … but volumes under pressure
Indeed, we are not the only ones expecting a price increase. Some shrewd investors are also quietly making a bet on the market improving. For it is not just short positions that are increasing: in contrast to what media is reporting, long positions have also increased by around 7.5 percent. These investments are based on the expectation that after some further declines a potentially sharp V-shape price rally is on the way.
Our assessment is largely based on two factors in the market: a simultaneous and mutually reinforcing decline in investments and revenues seriously undermining production. Falling crude (and refined product) prices have been slashing global energy investments, especially in the upstream oil and gas sectors. This situation will require a major output reduction in coming months. It is impossible to escape this. The global glut will be reduced, initially slowly but increasingly building an upward pressure on crude prices. In the first half year, our expectations are that US output will be down by 1 million bpd, adding to increased production cuts elsewhere in the world by non-OPEC producers who no longer have the revenues to reinvest in production.
The EIA's Monthly Energy Review database indicates that overall global production increased year on year by 1.5 million bpd (by September 2015). However, that export increase is all based on increased exports from three countries: US (440K bpd), Saudi 550K bpd and Iraq 900K bpd. The increases from these three countries are all based on projects which were planned for and paid for before the price decrease and which are all coming on stream now. Apart from the production increases from these three countries, remaining worldwide production already showed a substantial decrease. If the production of these three countries – which as we note was not based on new investments or additional production projects, but just due to normal previously planned projects coming on stream – were taken out of the market, global production already would be 400K bpd lower year on year.
If one examines U.S. rig data, the true underlying situation becomes clearer. The number of active U.S. rigs at present is more than 60% lower than in 2014. The JODI database, compiled by the World Energy Forum, indicated that year on year crude oil production in the U.S. was down over October 2015. The EIA echoes these figures, suggesting that tight oil production decreased by 500,000 bpd in November 2015.
Moreover, debts are coming due. Most small and medium American oil companies have ridden out the decrease in oil price for the past 18 months by hedging their prices. Many are still receiving well above $50 per barrel for long standing futures contracts. The hedging has served them well, but most of those hedged bets will expire in the next 30-60 days. With most of the world’s oil analysts and traders predicting a long term low price for oil, small to medium oil companies will find it nigh impossible to bring in additional investment, causing a large number of American oil companies to declare bankruptcy in the next few months. This will cause a consolidation in the oil industry, as the big fish swallow the small, but production decreases will continue.
Iranian oil glut?
Analysts are also missing an important point about Saudi Arabia’s overall production volumes: that the current levels are the same as August 2013. And an increased amount of this production is not reaching the international markets but is being used domestically, partly for refineries, but also for power production. The only real volume increase has come from Iraq lately, which is showing impressive results in a very unstable environment.
Oil is geopolitics!
As any university student who has taken a Geopolitics 101 class would have been taught: “Geopolitics and energy politics are inseparable”. Yet today, analysts are consistently overlooking the impact of international politics on the oil price. While the world is focused on OPEC production levels, the cost of US shale or North Sea oil and their impact on global markets, we are missing the significance of Russian political developments. Russia, the second-largest non-OPEC producer (after the US), has been showing signs of economic and political despair (despite Putin’s personal popularity) and growing pressure on the oil and gas sector. Russia’s state-owned oil pipeline monopoly Transneft has published statements indicating that Russian oil companies may cut crude exports by 6.4 percent in 2016. This would have a tremendous impact on 2016’s oil market fundamentals. After challenging Saudi Arabia’s market share strategy, which has caused most of the current price decline, Russia is now in such pain that it will be forced to try to reduce the flow of oil onto the market, in a move to increase prices. If the Transneft statement is accurate, Russia could be removing around 450-460,000 bpd from the market, almost the same amount that Iran claims it intends to add to the market.
At the same time, after a long period of optimism inside OPEC countries, more and more members are facing economic disaster. Venezuela, Nigeria, Algeria, Iran and Indonesia (which has just rejoined the cartel) are finding it difficult to export crude oil at a profit. OPEC’s leading oil producer and proponent of the current oil glut, Saudi Arabia, is also feeling the heat but its large cash reserves and low production costs are keeping it afloat for the time being. Others, such as Qatar and the UAE, have openly questioned how long the current situation can continue before they have to cut investment spending. Pressure is building for a break in OPEC unity. We must emphasize again, deliberate production cuts are not necessary for a price rise this year, but any breach in the OPEC ranks will accelerate our expected price spike.
Deferred investments and projects to cause price hike
Consumers in developed countries and oil importing countries are currently enjoying an unexpected windfall. Crude oil prices have crashed, presenting consumers at the pump with very low prices. At the same time, Western governments are stepping up their efforts to counter global warming, signing COP21 agreements and investing in windfarms. Alternative energy supply is booming, supporting the idea that we are witnessing the end of the “Oil Era”. The negative reports published by major oil and gas companies, evincing rapidly falling profit margins and the firing of tens of thousands of employees, are trumpeted by anti-hydrocarbon lobbies in Washington and Brussels. This all adds to a general feeling of negativity towards the oil industry, but this is a fata-morgana: the near to mid term future is still hydrocarbon-based for most energy and production processes. The world’s economy needs oil.
Indeed, so much investment in production has been deferred that a crisis in supply is now inevitable. And while China and the rest of the world’s economy may be slowing down, it is not reversing – demand is still increasing albeit at a slower rate. We expect that an additional 1 million bpd will be required over the course of 2016 to meet global demand increase. With prices at the lowest since 2004, investment cuts have been enormous. At the same time, most international oil companies will have to borrow more money to preserve the dividends demanded by their shareholders. Delayed projects, sale of assets, bankruptcies of small and medium firms, the brain drain of talented staff and steadily increasing demand all contribute to the coming reduction in supply. Shell, BP, Chevron, Statoil and others have openly stated that they intend further to cut investments by around 25 percent in 2016. The total oil and gas sector has already cut overall spending for 2016 to $522 billion, after overall spending in 2015 was cut by 22 percent to $595 billion. Shell has recently announced that it will not take part in Abu Dhabi’s Bab-gas field development, as costs are seen as too high in the current market. Even in the national oil companies, such as Gazprom, KOC, NNPC or Sonatrach, investment spending is severely curtailed. Only Saudi Aramco is still investing in production. A key question here is how long can Riyadh commit itself to this investment as revenues dwindle? And of course the answer is a question of political will – Riyadh is using oil as a geopolitical tool and shows every sign of continuing to do so until it achieves its aims.
At the same time, no real assessment has been made of one fundamental factor of upstream oil and gas. ‘If you don’t invest in your producing field, production will decline’ is still a fact of life for oil fields. Oil companies need additional investments to maintain overall reserves. Producing means reducing reserves, resulting in a total decline of the overall position, if no new reserves are being discovered. With no investments, a field should decline between 6-12 percent per year. Six percent of 90 million bpd is 5.4 million bpd. Investment is needed to maintain production, but for two years we have seen major declines in investment. And we believe that investment cuts will increase this year, since most companies made their 2016 spending plans at a time when oil prices were expected to be much higher; the true effect of Q4 2015’s devastating price decline will be seen in revised investment plans this year.
CAPEX decline to hit future production 2020, leading to a long and sustained oil price boom…
Around $380 billion of CAPEX has already been deferred for future projects. This figure is based on 22 major projects worldwide or seven billion of oil equivalent of commercial reserves delayed between June 2015-January 2016.
The result of this investment decline will be dramatic. For the period after 2021, 1.5 million bpd of new additional output will not be available. This volume will increase to 2.9 million bpd by 2025. Possible new deferrals are also expected, as US E&Ps could reduce CAPEX by a further 30 percent in 2016.
Thus, while we see an increase in the oil price after mid-2016, we believe that this increase will not only be sustained, but will steadily increase over the next 48 months until we see the oil price reach and maintain triple digit figures again.
Wolves and Sheep…
The decisions made across the industry over the past two years to defer investment will have a detrimental effect on the future availability of the crude oil volumes needed in the market, and lead to a return to very high prices in the next few years. But in the meantime, current price fundamentals will also result in a volume decline this year. The first real changes in the market are expected to surface around the summer of 2016, as demand and production should be hitting the same levels. There will still be some price pressure on the market, due to the legacy of stored over-production, although the stored over production has already declined from about 2.4-2.9 million bpd in 2014-2015 to around 900,000 bpd in Q2 2016. By Q3, we expect that the stored over production will no longer be enough to satisfy market demands, and the oversupply problem will rapidly evaporate, leading to a sustained increase in prices.
How far the V-shaped recovery will reach is not clear, but indicators show that a price of $60 is quite possible by the end of 2016. This based on the assumption that no disturbance of the already very unstable oil market will occur. An inflammation of the Saudi-Iran crisis or a deterioration in Libya’s political and security impasse could further inflate the price; alternatively, a return of peace and stability to Libya could also undermine the price increase, though we think any political accommodation in Libya will not translate into a full return to international oil markets in 2016.
From 2017 onwards the cuts in investment over 2014 and 2015 will start to bite, and oil should continue its price climb, to over $100.
In our view, the option of going long in the market is now much more attractive than ever before. Maybe it is time for clever investors to become the lone-wolves in a herd of sheep.
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