Why Crude Oil Price Rebound May Be Slow

Global crude oil prices have fallen rather steeply over the past six months. The international benchmark Brent plunged from US$109.07 per barrel (bbl) on 02 June 2014 to US$51.08/bbl on 05 January 2015, and the West Texas Intermediate, WTI, from US$103.07/bbl to US$50.05/bbl over the same period (Figure 1).

The impact on producing companies and countries is becoming severe and current concerns are about the depth and duration of that price decline. Some analysts have cited the fairly rapid rebound of oil prices after the spike of 2008 in their expectation of a quick rebound from the current slump. Such expectations however, may be misplaced. The oil price shock of 2008 had very little to do with market fundamentals; in 2008, prices rifled higher even while the market was well-supplied, peaking by the middle of the year and then crashing by three quarters by the end of that year. Prices more than doubled about six months later.

Fundamentals

The current price slump however, is driven principally by market fundamentals. While the Organization of the Petroleum Exporting Countries, OPEC, has kept production within a narrow band around 30 million barrels per day (mbpd) for the past few years, non-OPEC producers, principally tight oil producers in the United States (shale) and Canada (oil sands) have been ramping up production and account for the major proportion of the current estimated supply glut of 2 mbpd.

At present, there are no indications whatsoever of any planned reduction in supply by any of the producer-countries. For example, OPEC has vowed never to cut production, no matter how low prices fall; the principal Gulf producers (Saudi Arabia, Kuwait, United Arab Emirates and Qatar) have about two and half trillion United States dollars in reserves, enough to enable them ride out any short-term storm arising from the oil price slump. Russia just reported her highest crude oil production ever, 10.58 mbpd for 2014.The United States, one of the highest crude oil producers ― thanks to the shale boom ― is currently producing at her highest levels in several decades, but there are signs the inflexion point for shale output may have been attained.

Asia ― principally China and India ― and to some extent, Europe, are major markets for oil producers. However, China’s economic output has weakened in recent months (the country’s 3.3% on-year fall in Producer Purchasing Index for December is fueling concerns) while theEurozone economic growth has slowed conducing to reduced oil demand.

With demand stalling and OPEC refusing to cut production, the markets then would most probably determine the supply shutdowns necessary to reduce the current oil glut. According to the consulting firm Wood Mackenzie, effective global production shutdowns will begin at a Brent price of US$40/bbl; for many other analysts, that is also a “floor” price for the oil benchmark.

The shutdowns should begin with higher-cost producers such as tight oil and deep offshore producers but the latter are more focused on the long-term and have deeper pockets to ride out short-term storms. The current focus then is on the tight oil producers in the United States (shale) and Canada (oil sands). While production breakeven prices for individual wells range from US$38/bbl to US$110/bb, taken as a group, the values are quite different. The Bakken Formation of North Dakota for example, is one of the most viable and liquids-rich of shale plays in the United States but a recent Reuters market analysis shows that an oil price of US$55/bbl is necessary for its economic sustainability; if prices, which are currently below that mark endure, the shale play’s viability may be threatened.

Already, there are signs of declining production activity in the U.S. shale plays. The number of drilling rigs operating in North Dakota for example, just a few days ago fell to their lowest level in more than four years. Rig counts are indicative of the level of drilling activity in oil producing regions; granted that operational efficiencies have conduced to deployment of fewer rigs, a steep decline in the number of operational rigs is therefore indicative of a significant downturn in activity.

While current oil prices are well below breakeven values for a good proportion of producers, there is no rush yet to shut down operations. Some producers are currently hiring storage facilities to stow away their products and sell at a later date when prices rebound substantially; and this has caused a spike in tanker as well as other storage rates. For producers such as those involved in oil sands and mature offshore fields, the decision to shut down could be complicated as shutdowns are often expensive and may be irreversible. The option is often to operate at small losses and recoup when prices rebound.

Even when production shutdowns come into effect, the rather sluggish economic activity in Asia and Europe would mean a slow growth in global oil demand.

All said then, save for extenuating circumstances (war or the equivalent) which may suddenly force swathes of producers offline, crude oil price rebound will most probably be slow.