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Today we are going to discuss the past present and future of crude oil since the dynamics of the Oil Prices are quite interesting, and understanding them can help you get a grasp on how the financial markets function. It’s all about supply and demand!
- Why the huge 2015 sellout?
- Why are we experiencing oversupply?
- Who is being affected the most?
- How does the future look like?
Why the huge 2015 sellout?
Take a look at this chart, as many have said before one image speaks more than 1,000 words…
18 Months ago Crude Oil was trading above $100 a barrel, how is it possible that yesterday, Thursday 17th of December, marked a low below $35? In one word: Oversupply.
In any “free” financial market prices are set by the, both invisible and magnanimous, forces of supply and demand. If you see the price of anything, literally anything, going down, the ultimate explanation lies in its supply and demand. In the oil case, the demand hasn’t gone down, it has actually gone up in the past year. This leaves as with one possible scenario; the supply of oil must be growing at a higher pace, and at a much higher pace to provoke such a hefty correction in its price.
This is exactly what we have seen. At this moment the world is flooded in oil. There is an excess in supply of over 2M barrels per day (bpd) which has already put the inventories of the Americas, Asia, and Europe at 4.4 billion barrels. A sizeable increase compared with the average of 3.8 billion barrels seen in the past 5 years. This is creating an unsustainable situation since the on-shore storage is starting to run out of free space, and the amount of oil at sea has, at least, double since the beginning of 2015. You can find more specifics on the numbers in this Zero Hedge post
Why are we experiencing this oversupply?
Any curious reader, that doesn’t know more about the matter, is at this point asking him/her-self why the heck is this oversupply in place? Wouldn’t the oil producing countries want to keep the supply low in order to charge higher prices? That indeed was the case until a group (actually a cartel) that goes by Opec, and specially its more powerful member, Saudi Arabia, started to feel threaten by the possibility of losing market share to Non-OPEC nations.
Saudi Arabia decided to block the calls from weaker members of the OPEC for production cuts 1 year ago, it repeated this action this month, and marked a major shift away from the common practices of price control. In that meeting held in Vienna on November 27th 2014, the OPEC nations set the stage for the major battle for market share that we are experiencing today between the OPEC and non-OPEC countries.
The Saudi Oil Minister, Ali al-Naimi, walked out of the meeting quite happy with the result, and the market might already be showing that the Saudi’s move was not only bold, but also appropriate. According to the International Energy Agency, the Non-OPEC oil annual supply growth sat this past November at 300,000 barrels per day, while at the beginning of 2015 was at 2.2 M barrels per day. A further 600,000 barrels per day decline is expected in 2016.
Who is being affected by the Oversupply?
The truth is that all the oil producers, OPEC and Non-OPEC, are suffering the consequences of such a big move in the price of oil. Even the main advocate for this market share war, Saudi Arabia, has been wounded by the move. Saudi’s fiscal deficit sits above 20% of its GDP and its credit rating was cut by S&P to a level of A+ this past October. To give a big picture, the OPEC oil related revenues will most likely be around $400 Billion this year when in 2012 stood at $1.2 Trillion. However, despite of the fact that the OPEC nations are suffering the consequences, they have the resources to keep their economies on check while they run their competitors out of the market. Many exploration and drilling companies have already filed for bankruptcy and if prices stay at these levels this is just the beginning.
The following chart shows the cost curve of the different oil being supplied to the market.
As you can see, Oil Sands, Shale oil, and ultra Deepwater are the most expensive ones. This is why Canada, the U.S. and Norway are being hit the hardest.
Canada sand oil
Canada has the world’s third-largest oil reserve in the world, worth billions of dollars. However, it is also the most energy intense and expensive. It is important to know that the Canadian crude trades at discount in comparison to the U.S. crude, due to both quality and cost of transportation. With a difference of $13.75 a barrel, the outright price sits at $22 a barrel. At this price over three quarters of the 2.2 Million bpd produced by Canada are yielding losses. Since Canadian producers are not able to cut productions due to the high costs already incurred, the only solution is to cut spending by renegotiating supply contracts, worsening the conditions of the workers, and laying off staff. The spending budget is, on average, around 40% lower for 2016 than the one for 2015.
North America Shale Oil
North America Shale Oil is thought by many to be the main target of Saudi’s actions. As this week, oil exploration in the U.S. is down 65% and gas exploration is down over 44%. The numbers speak for themselves, since the OPEC decided to flood the market with oil the U.S. has seen a decrease in the number of active oil rigs from 1,895 to 709. Check the following chart:
In any case, it is important to understand that U.S. shale production is quite flexible and highly responsive of oil prices due to the low barriers to entry and exit. Shale oil acts as a market-driven swing producer. The U.S. oil production is down by almost 500,000 barrels per day from the recent highs, however, when prices rise again crews can start drilling and fracking again, and take the production at previous levels in a matter of months.
Norway Ultra Deep Water
The 2015 oil prices collapse has already taken its first victim in the Norwegian space. Dolphin Group ASA, a seismic surveyor that searches for oil and gas reservoirs, filed for bankruptcy this month. The offshore investment will experience its largest fall since 2000, and it is expected to fall further in 2016. This is leaving drilling companies living off their existing contracts, and if the prices stay low they will soon face deep financial issues. But not only exploration and drilling companies are suffering. Producers and other service companies are feeling the heat. Statoil ASA, the biggest oil producer in Norway, is planning a workforce reduction of almost 4,500 employees. The biggest offshore engineering company, Aker Solutions ASA, will be also cutting jobs in the near future.
How does the future look like?
Anyone can take a look at the numbers and think that the OPEC is achieving its goal; U.S. shale producers are being driven out of the market. This analysis will mean that soon enough we might be seeing a rebound in the price. However, this is just the surface, and we like to get dirty and find out more. After careful consideration it seems to us that oil prices might stay in this level for much longer than previously foreseen, and it might even drop to prices not seen in decades. Why?
Saudi Arabia’s real agenda
Many think that the OPEC is not cutting its production in order to drive the U.S. shale oil producers out of the market. The U.S. shale sector is an important player, however, as already mentioned, U.S. shale producers have the flexibility and responsiveness to changes in price due to low barriers of entry and exit, and the OPEC knows this. This is why the OPEC is not going to be looking at the statistics on U.S. rigs sealed in order to decide wether to curb production or not. What is going to matter is the delay and abandonment of important, expensive, and lengthy oil plays, especially of from the big oil companies.
The Saudis know very well that if they are able to weather the storm for a couple of years they might be able to delay multibillion-dollar explorations and production projects. If these projects get cancelled, the oil production will drop naturally in the future and the OPEC country’s will retain, or even increase, its market share.
The cuts in these mega projects are already taking place.
- Wood Mackenzie has delayed projects for over $200 billion tied to 20 billion barrels of oil
- Chevron is planning to delay its $5 billion development in the Gulf of Mexico project for at least three years.
- ConocoPhillips has completely abandoned its deep-water exploration
BP is, with Chevron, the company that has deferred the largest number of projects, while Exxon is the one that could delay the largest amount of oil barrels (close to 2.5 M bpd). Royal Dutch Shell is next in the line deferring 1.7 M bpd
If this cuts keep on coming and materialise, we would expect a deep supply depression in future years.
We cannot forget Iran. The potential lift on the Iranian sanctions could add enough supply in 2016 to offset any expected decline from the U.S. production. So, this is why we shouldn’t expect any rebound on oil price due to short-term lack of supply next year.
The nuclear accord reached in Vienna will provide the holder of the world’s 4th biggest crude oil reserves the opportunity to export more oil in return for curbs on its nuclear program. Bijou Namdar, Iranian oil minister, declared that they can increase exports by 500,000 bpd as soon as the sanctions are terminated and another 500,000 bpd 6 months after that.
The Cash Cost Curve
Finally, there is another big reason why, despite of the low oil prices (low if we compare them with the past years) we can still expect farther retractions. This chart in which we can see the cash cost of the major oil producers paints the picture.
In order to see the major oil producers halting the current production levels, we need to see lower oil prices. This cash cost represent the absolute minimum price at which producers will keep their operations running. Due to the technological advances that are making oil drilling cheaper and more efficient the production costs have come down.
It is also notable that many oil producers are heavily indebted and they rather keep on pumping oil and selling it to pay back the debt than shutting their operations until the prices come back up. So, at current prices, even well above $30 pb, producers still have a huge incentive to keep on pouring into an already oversupplied market.
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