Crude Oil Prices And The Lingering Uncertainty

Crude oil prices have plummeted by more than 70% over the past 20 months, to twelve-year lows. The impact on both producing companies and countries has been significant. Major oil and gas companies have seen large dips in profits. In 2015, BP suffered its largest annual loss in two decades while ExxonMobil, Royal Dutch Shell and Chevron had 50%, 80% and 76% decline in earnings respectively, for the same period. ConocoPhillips cut its dividend by about 66%. Revenues for members of Organization of the Petroleum Exporting Countries, OPEC, are expected to slump to about US$400 billion from US$1.2 trillion in 2012. Azerbaijan and Nigeria are mooting emergency loans from the International Monetary Fund, IMF, while many analysts are expecting a Venezuelan default on her foreign debt. Even Saudi Arabia’s fiscal reserves fell to a four-year low last year.

Market Uncertainty

While the current turmoil in the global economy derives from concerns about the health of the global economy, the impact of oil prices contributes in no small measure. As China, a major energy ― especially oil ― consumer transitions from an emerging market to a developed one, a marked reduction in her growth rate may be the new order. During her years of steep economic growth, China was an export destination for commodities from countries such as Russia, Brazil, Chile and Nigeria among many others. The downturn has meant falling demand for these commodities and with falling oil demand has come falling oil prices. The current capital flight estimated at tens of billions of dollars per day, is a testament to the country’s influence on global markets.

While the shale producers in the United States have shown unexpected resilience in the face of low oil prices, it is doubtful if the debt-ridden operators can sustain operations at current crude oil prices. WTI (CL1:COM) closed US$27.32 on Thursday.

Very few, if any significant oil producers in the United States are cash flow positive at US$27 per barrel of oil. Between 1Q 2012 and 2Q 2015, debt service as a share of operating cash flow almost doubled for United States onshore oil producers. In 2015, United States oil and gas bankruptcy filings spiked by 379% over the 2014 level. Moody’s just downgraded eight US oil and gas companies, increasing their borrowing costs and likelihood of credit default.

Concerns about investors and financial institutions exposed to producers have escalated. According to the US Federal Reserve, investors such as hedge funds, insurance companies and private equity funds hold most of the debt issued by these energy companies. While such debts amount to only a small proportion of exposure for the biggest United States banks, all it takes is a fit of panic for a market rout to ensue. The uncertainty has led to a flight to safety for many investors, with gold a refuge place. The price of gold has spiked to an 8-year high.

Fundamentals

With a sustained, positive oil imbalance (excess of supply over demand), that uncertainty may linger. While global demand growth is projected to slow somewhat this year, there is no indication of a countervailing reduction in supply.

In a drive for market share, Saudi Arabia and Russia have been producing at near peak capacities and Iran has been, since the lifting of sanctions, rapidly ramping up output. The economies of both Saudi Arabia and Russia have been heavily impacted by falling oil prices, but the former has conditioned its support for supply cuts on the willingness of all other producing parties to do the same. However, an attempt by Venezuela’s energy minister to broker production cuts among major producing countries has not yielded any fruit. Hopes for a coordinated production cut on recent comments by United Arab Emirates’ energy minister, are seemingly fatuous at best. With the emphasis on market share, any negotiation for supply reduction should include US shale producers, largely responsible for the marginal supply increase.

That may be a rather tall order since there is no governing representation for that body of producers. As hedges, their latest holdout, are expiring and with little chance of any meaningful renewals, production economics may well be their only governor. The production decline rate however, has not been steep. According to the Energy Information Administration, supply from seven major US shale plays is expected to fall by 92,000 barrels per day, bpd, in March.

Prospects

A major effect of the fall in crude oil prices has been the cancellation or deferral of development projects. The consulting firm Wood Mackenzie recently reported that a total of 2.9 million barrels per day of liquids production has been deferred to early next decade. In addition, maturing oilfields are often allowed to “die” since production revenues do not justify the expenditure required to sustain them. The implication is that future supply may be inadequate to meet a rebounding demand, causing a price shock.

By electing to “ride out the storm”, some oil companies with large financial muscle may be betting on exchanging short-term pain for longer-term gain. The lighter weights such as shale producers, which present high initial production decline rates, and require continuous drilling just to maintain output, may not have such luxury.

Contrary to expectations, shale output would most likely not witness a rapid increase with an oil price rebound. This is because many of the long-idled equipment in the services subsector ― usually the most impacted in a falling oil price regime ― if not in disrepair, would have been sold-off as parts to recoup costs. Argus reports that US oil and gas rig count has fallen by 72% from last year’s peak of 1,930, the lowest since 1999. Moreover, many bankers and investors may not be quick to rejoin the supply train since a rapid supply output would only lead to another price slump.

Crude oil will over the next few years, remain a significant, even if declining proportion of global energy utilization; and given its boom-bust cycles, prices will rebound. However, the timing and extent of that rebound remains to be seen.