HINDSIGHT: Promises and perils of oil market in 2017
- Written by Laurentiu Rosoiu
From mid 2014 to the end of 2015, the oil price registered one of the largest declines in history, bringing along severe cuts in investment budgets and massive restructuring in the oil and gas companies. The revolution brought in by the hydraulic fracturing in the US, the OPEC policy of maintaining the market share, the lifting of sanctions against Iran and the weak growth prospects for the global economy are the most important elements that have created and maintained this trend. At the end of 2016 some of these realities have changed, whereas the oil price has already embarked on an upward trend. The question is: how strong is this trend?
At the end of 2015 the Brent oil price had reached the level of USD 35 per barrel, down from a peak of USD 115 per barrel recorded in mid 2014, and in the first half of 2016 it reached a minimum of USD 28.81 per barrel! None of the successive falls below the support thresholds during this time have determined OPEC to change its approach: the members of the oil cartel preferred to maintain their market share and thus keep the high output level despite the price fall, at the expense of restoring the production quota system that would have prompt the prices increase on the market. During this period, each new OPEC meeting (all of them resulting in lack of agreements to cut production) has been one more reason for another round of falling prices! This happened until the oil fell below the USD 30 per barrel threshold; consequent to this point, the perception and the market expectations have changed, and as a result, the OPEC meetings, during which it was reiterated the policy of maintaining the market shares, haven’t had the power to push the price downwards (see the chart ‘Brent oil price during 2014-2016’). Therefore, the decision in late September, which targeted output limitations, was made against a background of an already outlined growth, pushing it spectacularly upwards: in only several trading sessions after the September 28 moment (when the OPEC decision was made) the oil price rose by more than 13% (see the graph ‘Brent oil price after September 28’).
END OF THE TREND
During the downward trend of about one year and a half (from June 2014 to December 2015), the oil price went lower and lower from threshold to threshold, whereas all companies in the oil and gas sector have reacted with aggressive cuts in investment budgets. They started on the budgets for 2015, but even so the industry players were taken by surprise by the further evolution of prices, as expectations (and plans!) entailed a stabilization in oil prices around the threshold of USD 55-65 per barrel. Therefore, late last year, when oil fell by another about 40% below the expected level on the market, it generated a new negative wave.
One explanation for this development is, according to experts, that the market was in a period of over-extension of the downward trend; a phenomenon caused mainly by the ‘war’ declared by the traditional oil producers (OPEC, to be precise) to the US companies that were using hydraulic fracturing – ‘war’ with the explicit goal of removing the latter from the market.
The hydraulic fracking technology is the one which brought the huge output surplus in 2014, which made the oil supply volume grow despite the massive investment cuts made since 2015. The widespread use of hedging instruments, the cuts in costs and/or the efficiency and productivity increase of these operations, especially that the producers were often forced to actually produce and sell oil irrespective of the costs and prices in order to generate the cash needed to cover the assumed liabilities are the main elements that have led to this phenomenon (of increasing the production from alternative fields despite lower investments).
Therefore, 2015 was dominated by two trends: on the one hand, the continued growth of oil supply and, on the other hand – an increasingly weaker demand! As a result, we had an oil price with many unknowns until sometime in the second half of 2016; that is the year in which oil producers seemed to have already accepted the idea that ‘low prices are a reality over the long term’. Thus, a new round of drastic budget cuts in investments and layoffs was reached. The evolution of supply-demand ratio in 2015 actually supported this view and, consequently, the companies’ decisions related to another round of restructuring. According to the US agency Energy Information Administration (EIA) the global production of liquid fuels increased in 2015 by 2.2 million barrels/day (mbd) while the demand growth was of only 1.4 mbd. The difference was seen in the growth of stocks, which reached a new historic high of about 3 billion barrels (see the chart ‘Development of global demand and supply of liquid fuels’).
In this context, however, it is to be stressed - if we talk about traditional producers - that by mid-2014, when oil prices started decreasing, a significant part of the new ongoing exploitation projects were continued. This explains the fact that despite an aggressive price cut, none of the traditional producers could radically change the production curve! This led to a global output increase of about 1 mbd starting with Q4 2014 to the same quarter of 2015 in this sector too (the traditional technology exploitations). Paradoxically, this paradigm still seems not to be outdated because, despite a substantial oversupply, there are still many projects about to begin actual production, mainly in non-OPEC countries. At least this is what the Deloitte experts say - one of the leading global consulting houses. According to them, at the end of 2016, there are no less than 90 projects worldwide that are very close to production, with a potential aggregate capacity of 6.4 mbd roughly during the next five years. More than 65% of this potential output would come from the former Soviet Union countries, Europe and Brazil; but the most consistent contribution would be made by the countries of the former Soviet space: more than 1.6 mbd (see the graph ‘Ongoing projects to go into production by end of 2016 in non-OPEC countries’).
Deloitte calculations are based on data published by the International Energy Agency (IEA) at the end of 2014, which were supplemented and updated using information from various public sources, such as company reporting or articles in the specialised press.
THE OPEC AND THE US OUTPUT
As the oil producers’ organization is the main player on this market, it deserves special attention. In 2015 the Organisation’s member states production slightly exceeded 32 mbd; at the meeting on September 28, the output level agreed by all OPEC members is of 32.5-33 mbd - Iran will not be subject to these limitations (a major concession made by its eternal rival Saudi Arabia).
What must be considered is that the arrangement of output capping comes in a context in which the ability of key OPEC members to increase the output seems to be rather limited. This is true at least if we look at the main players on the market, namely Saudi Arabia, Iraq (which contributed about 1.2 mbd to the increase of production in 2015) and Iran (the third player on the market), which appears to be already close to their maximum production capacity in the current market context.
A short overview of the arguments made by specialists in this regard may point out that Iran is already very close to the level achieved prior to sanctions (which was about 4 mbd), with a peak of about 3.5 mbd of oil in the first half of 2016. In Iraq, the number of wells drilled has dropped to about half over the past about two years; whereas Saudi Arabia has not managed to bring into service any new project to offset the 37% fall in the number of drilling wells recorded at the end of July 2016 as compared to the peak in 2014. This comes in a context where risks and tensions in the region contribute to a rather modest prospect on the level of investments in the Persian Gulf. By extrapolating the data and information of this type in its own model of analysis, the Deloitte experts argue that unlike in 2015, when the total output of OPEC members registered an increase of 3.2%, at the end of 2016 the extra production will be halved (only 1.6%).
Regarding the United States - the player who helped trigger and amplify the downward trend of oil price through the oil producers from alternative fields - it requires an analysis of the three main pools of extraction: Permian, Bakken and Eagle Ford. The same EIA data show that, despite the market fall, the Permian Basin production continued to grow: in the whole year 2015 the average daily production was of 1.9 mbd, by 272,000 barrels per day (bd) higher than in 2014.
The use of hedging instruments and the significant efficiency gains are the main reasons for this production development, which continued in 2016. According to calculations made by the same Deloitte specialists, the average daily production in the Permian Basin could reach 2.1 mbd in 2016. By comparison, in the Bakken basin the output began to decline after the peak reached in June 2015 (1.24 mbd) therefore, for the entire year 2016, Deloitte estimates that it will reach a daily average output of about 1 mbd. Unlike the first two, the Eagle Ford basin production, following a maximum of 1.7 mbd recorded in the first half of 2015, it has decreased by 287,000 bd by November the same year; the result of the estimates made by Deloitte show that according to the pattern used for the entire year 2016, the daily average could fall to a level of 1.0 mbd.
As a result, the overall production in the three main alternative oil basins in the United States at the end of 2016 will register an average decrease of 700,000 bd, the Deloitte pattern shows; as far as the production of the rest of US producers, having as source mainly traditional fields, it will remain constant, according to the same estimates. Consequently, according to the Deloitte experts, the US oil output will stagnate over the entire year 2016 on an average level of about 8.7 mbd... in line with the EIA estimates – the US specialized agency.
DEMAND IN THE US, EUROPE AND ASIA
On the other hand, despite the fact that over the recent years the demand was significantly under pressure from the lack of confidence in world economic recovery, last year was one with growing consumption! According to the EIA, IEA and OPEC estimates, demand for liquid fuels in 2015 registered an increase of between 1.5 and 1.8% (see the chart ‘Global liquid fuels demand development, by reporting entity); the largest contribution came from the US, Europe, China and India (and other countries in the Asia-Pacific and Middle East areas). And the trend has continued in 2016! At least this is mentioned by the ‘Monthly Oil Market Report’ published by OPEC on October 12, which indicates an increase in global demand of 1.24 mbd to 94.40 mbd - level up by 10,000 bd as compared to the previous month (due to higher than expected growth in demand in the Asia region); the prospect in the OPEC report is confirmed by the IEA and EIA estimates. While the IEA estimates indicate a demand growth rate of 1.3% in 2016 - lower than the one recorded in 2015, EIA estimates for 2016 a demand growth rate of 1.5%.
All three estimates for 2016 are however pessimistic in terms of demand from OECD economies, for which the growth is estimated to be between 0 and 0.3 mbd - less than half the level recorded in 2015. By comparison, all the estimates are optimistic regarding the expectations about demand in the non-OECD economies, anticipated to increase by another 1.0 mbd, in particular due to the auto fleet growth expectations and of the mileage in China.
Based on previous data, Deloitte analysts argue that the annual demand growth rate will be of 0.22% for OECD economies and of 2.28% for non-OECD economies. Counting on a conservative estimate for China (being considered the estimates envisaging a fall in the rate of growth), they use a demand growth rate for non-OECD countries of 1.5% to forecast the demand during the next five years. On this pattern, Deloitte estimates that global demand for liquid fuels will increase in 2016 by 1.5% against the previous year, and an annual rate of 0.9% as of 2017 until 2020 (see the graph ‘Estimates on oil global supply and demand’).
The Deloitte experts’ available estimates are however conducted based on the premise that in that timeframe no additional exploitations will go into production against those already taken into account and that any eventual amplification of the oil price increasing trend can bring new producers on the market.
The risks of such unexpected events is however moderate by the fact that the going into production of new exploitations, other than those already considered, are unlikely to take place quickly, as it usually involves a relatively long period. Such surprise appearances on the supply side may yet come from the oil producers from alternative fields in the United States or possibly from OPEC members - where there are still a number of conditions that can foster such a phenomenon. This development is quite complicated even for the American producers, as increasing interest rates are considered and the equity holders will very likely be more reluctant to provide financing, the Deloitte experts say.
In the current context, there are several outlooks on the oil price pattern. Will it be in the ‘V’ or ‘U’ shape? A first step to be done in order to try answering this unknown is to look back. So if we look at 2008-2009, when there was a collapse in terms of price and demand (demand decreasing annually by 2.3% during the two years), we can see that the OPEC intervention (which was prompt to cut the output) was the element that strongly supported the price recovery in 2010 - which outlined a ‘V’ shape comeback.
But things are different now. The drop in oil prices comes amid a surge of supply and not a decline in demand - which made OPEC members reluctant to cut down the output, while intending to preserve their market share. This reality is the argument brought forward by analysts who argue that the return in prices will occur this time more likely on a ‘U’ shape, but extended to the bottom, which would allegedly take place in three stages/phases; this means that the market will face low oil prices for a longer time. The development will take place gradually, to the extent that is supported by higher demand and a decline in natural reserves exploitation; according to the Deloitte analysts this will move the potential oil prices recovery moment to the pre-crisis levels (i.e. above USD 100 per barrel) sometime after 2020.
Thus, in a first stage, the Deloitte say, we may deal with a rebound in oil prices at USD 58 per barrel - at a slower pace until 2018, as a result of the supply-demand ratio development. From this point, however, due to productivity gains and efficiency coming from technological progress and to cost cuts of auxiliary services, the US oil producers by alternative technologies will have the motivation to return to the market. This will cover part of the shortfall in global output due to the depletion of classic deposits. This would be only short-lived - until 2018, as Deloitte experts say, as the continuing trend of falling volumes extracted by traditional oil producers will not get a consistent response on the supply side, unless investments are resumed in countries such as Iran, Iraq, Brazil and Russia.
In conclusion, most analysts agree that the changes in the oil and gas industry in the past about two years will lead to higher oil prices, even if there is a no common perspective on price levels and timeframe. For example, according to the latest estimation by the US Agency EIA, the oil price will reach an average of USD 43 per barrel in 2016 – by USD 1 per barrel higher than in the previous estimate. A similar estimation on the average price in 2016 comes from the World Bank analysts: USD 43 a barrel - a modified estimation also upwards following the return of optimism on the market.
A little bit most optimistic seem to be the Bank of America Merrill Lynch (BofA) analysts, who, at mid-year, published a report which estimated an average price of USD 46-45 per barrel (for Brent, respectively WTI oil) as average for 2016. For 2017 other differences are to be noticed, although they are not major: thus, the EIA estimation is of USD 51 per barrel (by USD 1 per barrel lower than the previous one); in contrast, the World Bank takes a more optimistic estimation price: USD 55 a barrel - a level by two dollars higher than the previous estimate. A more conservative estimate comes from the analysts of the US financial giant Goldman Sachs, who argue that the OPEC agreement on capping production will have a short term support on the price and will not affect the output level. On this reasoning, they have informed the investors they maintain the estimates of USD 43 per barrel for 2016 and of USD 53 for 2017.
In conclusion, despite some differences, the prospect of increasing oil prices is the common element of the estimates with relevance on the specialized market - which reveals the return of optimism in the sector, an optimism that comes from the changes operated in the industry’s structure in the two years of decrease. Hydraulic fracturing shows its limitations, the effects of the decisions to cut investment budgets begin to be felt, OPEC has eventually reached an agreement (with many question marks still pending), in support of the oil price, whereas Iran does not have much room to increase production without conducting fresh investments. This is the image of 2016. It is radically different against 2014 or 2015 and still changing, looking forward to 2017...