InvestmentsApr 23 2015

Crude estimates

twitter-iconfacebook-iconlinkedin-iconmail-iconprint-icon
Search supported by
Crude estimates

Just over six months ago, the consensus opinion was that US$100 /bbl oil prices would be here to stay for the long term.

For four years we saw oil prices hovering at around $100 per barrel and the world economy was doing ok.

The easy rationale was that Saudi Arabia, Kuwait and the United Arab Emirates would defend oil prices at this level as their economies had got used to the fruits of US$100 oil, and their production could be reduced, having been substantially above their historic averages. We, among many others, thought it likely that Opec would cut production to defend prices.

The Opec decision at the end of November 2014, essentially to defend market share, came as a surprise to many commentators. The decision makes it very clear that, for the time being, Saudi Arabia wants to maintain market share and put pressure on the US oil producers that have borrowed heavily and reinvested aggressively in new unconventional oil production over the past five years.

In many ways, it is not dissimilar to the market volatility brought about by the father of the US oil industry John D Rockefeller when he gave his higher-cost competitors a “good sweating” a century ago by driving oil prices down and putting them out of business.

So, the industry is in the process of adjusting to sharply lower oil prices, and it is not an easy adjustment to make.

There is no clarity over the short-term direction of the price of crude oil and there are divergent views between well-regarded energy companies and commentators on where crude will be in coming months.

At a recent energy conference we saw contrasting views between industry heavyweight, ExxonMobil, forecasting US$55/bbl oil for the next few years, and the darling of the US shale oil industry, EOG, forecasting a substantially higher oil price by the end of this year. Will the recovery in price be ‘U-shaped’ or ‘V-shaped’?

Energy analysts are no better. When oil was US$100/bbl there was very little difference between energy analyst forecasts, but now, as an example, there is more than US$30 a barrel of difference between the oil price forecasts for the end of 2015 of Francisco Blanch at Merrill Lynch and Paul Horsnell at Barclays.

The oil industry has many periods of over-supply in its history to draw on as parallels, but the key unknown this time is shale oil activity and how shale production will react to lower oil prices.

We see an oil market today that is well-supplied, which constrains price, but maintain our view that oil prices need to increase in order to incentivise significant new oil production over the medium-to-longer term.

US oil production has been growing at around 1.5 million barrels a day (near peak levels), Iraq production has improved, and there are overhangs elsewhere within Opec in the form of higher post-sanctions oil production from Iran and, potentially, greater production from Libya. These factors have put the 93 million bpd global oil market into oversupply of between 1.0 and 1.5 million bpd, causing the oil price to more than halve.

If Iranian and Libyan production returns and the US continues to grow, there is a real risk that oil prices will go lower before the recovery begins. Near-term prices would need to fall sharply forming a steep contango in the oil futures curve and incentivising traders to store crude oil in offshore tankers.

There is a real risk that oil prices will go lower before the recovery begins

This situation is most likely to happen in the US since laws exist that prohibit the export of crude oil from the country and have forced much higher levels of oil storage in the country. It would represent the start of the oil market healing process.

We expect the balance of the global oil market to improve through 2015, with North American oil-production growth starting to slow during the first half of 2015. This will likely result in particularly anaemic growth from North America in 2016. Capex in North American oil is down 40 per cent year-on-year and the oil-directed rig count is down by 50 per cent from its peak.

There will be some offsetting factors – efficiency gains, companies will focus on only developing their best wells, service cost improvements – but we think it inevitable that oil-production growth will slow sharply. But we will only start to see this coming through in the data from May or June this year.

While the investor base appears solely focused on North American oil supply, we note that the world outside the US is actually much better balanced in terms of oil supply and demand. Non-Opec production excluding North America has not grown over the past four years. Recent project delays, cancellations and the diversion of capital away from these regions point to production continuing to decline.

Coincidental with this, we observe that global oil demand is showing clear signs that it is strengthening. While the International Energy Agency estimates that global oil demand grew by 0.7 million bpd in 2014, the most recent data, for February 2015, indicates year-on-year growth in that month of around 1.5 million bpd. What is more, the demand growth looks well-balanced across the US, European and Asian economies. Interestingly, India has now announced that it is using the current low oil prices to start building strategic oil inventories for the first time.

So, the short-term trajectory for oil is unclear. The next few months will be very telling and, as ever, the data that eventually demonstrates that global oil supply and demand are in balance again will be very backward-looking.

Jonathan Waghorn is co-manager of Guinness Global Energy Fund

Key points

The Opec decision at the end of November 2014, essentially to defend market share, came as a surprise to many commentators

The key unknown is shale oil activity and how shale production will react to lower oil prices

We expect the balance of the global oil market to improve through 2015