EVEN LOWER, FOR EVEN LONGER: The Implications of OPEC Inaction
/The official communique from the latest OPEC meeting in Vienna on 4 December 2015 suggests an organization prepared to sit back and watch what happens as a result of Iran’s anticipated return to market in early 2016. But it is what is not written in the communique that matters most to participants in physical oil markets – any evidence of compromise or concern with the present state of affairs.
OPEC is a consensus organization. It takes no action without unanimous agreement of the twelve (now 13) members. The lack of any change at the December meeting does not, however, imply concord or satisfaction among the member states. Rather, it implies a lack of unanimity to any course other than status quo ante. This despite the very public and vocal criticisms of the current “anything goes” approach that preceded this latest meeting from a number of quarters, including Venezuela, Ecuador and Algeria. Some members clearly want a production cut, but they are not willing or able to cut alone – the actions of any smaller members would have an outsize impact on the cash flow and national budgets of these states, many of whom are almost wholly dependent on oil for export earnings.
What happened in Vienna was a tacit recognition that we could be about to see OPEC producing a lot more oil than at present and that we may be in for an extended period of market oversupply. The crude oil price slid further in the aftermath of the meeting and is now testing levels below $40/bbl Brent that are uncomfortable not just for non-OPEC producers but also for a number of higher cost OPEC producers, including Venezuela, Ecuador and Angola.
OPEC’s own most recent estimate of the scale of oversupply – the gap between the now-meaningless “call on OPEC” and the current OPEC output – is 2.3 million bpd. KBC’s own estimate, based on accumulating global oil stocks, is closer to 1 million bpd. Without agreeing on the scale of overproduction, we can all understand the implications of a market that continues to produce far more than it consumes. Global storage is filling up; oil prices are starting to slip and there is a real concern that oil prices may slip considerably further, with Goldman Sachs recently repeating its view that oil prices could need to drop to $20/bbl for some time before the oversupply is finally stopped – either by the closure of more producing capacity or, finally, by some joined-up intervention by OPEC and perhaps by some non-OPEC producers.
The very real questions arising from the latest OPEC inaction are, “How low and for how long?” and “What are the implications of this prolonged period of lower prices for physical market participants?”.
“How low and for how long?” – When Will Prices Start to Increase?
Strictly speaking, OPEC is not wrong to take a “wait and see” approach to Iran’s return to the market. Most expect Iran will raise net exports in 2016 by around 500,000 bpd, this being a mix of crude oil and condensates from its enormous South Pars reserve. There may be more upside for Iran, but much of this will depend on the return of foreign investment and expertise to ramp up the exploitation of its massive untapped reserves, and this in turn depends on the attractiveness of the new Iran Petroleum Contract, which is being introduced to the market over the next few months.
Beyond Iran’s return, the stated aim of OPEC’s policy is to preserve market share for OPEC members, but any rise in OPEC’s output, apart from some putative spare capacity among Middle East Gulf producers, may be significantly impaired as a result of the lower price regime. OPEC members are just as susceptible as other producers to the challenges of lower prices. The long run result of OPEC’s action will be a slowing of the rate of new production to market from OPEC and non-OPEC producers alike.
KBC anticipates that oil prices will start to recover toward the end of 2016. Seasonal demand in the Northern Hemisphere summer – the so-called “driving season” – was very strong in 2015 and is expected to remain strong in 2016 as cheaper fuel and an upturn in the purchase of SUVs and larger cars support growing transport demand. Cheaper oil also stimulates demand for air travel, domestic heating and petrochemicals. When the market starts to tighten, which we assume will happen toward the end of 2016, the global stock overhang will start to unwind and prices will need to rise to signal to marginal producers – especially to US shale oil – that more oil is needed. We expect this will give rise to oil prices topping $60 before the end of 2016 or in early 2017. Once prices stabilize, we expect they will have a slow and steady increase as the market is supplied on the margin from a mix of new LTO and OPEC output, plus some moderate new output from supplies in the North Sea, Caspian and Canada.
Come Rain or Come Shine
Volatility has been a central feature of oil markets since the oil shocks of the 1970s. There is nothing especially drastic about the current situation to suggest that “this time it’s different.” The oil price fell from $140/bbl to $35/bbl in 2007-08 – far more than the current cycle. Oil dropped below $10/bbl in 1998-99 and it finally took an intervention by OPEC and non-OPEC members to tighten up supply and raise output. It is clear that OPEC could easily rebalance the market, even by adhering to its nominal production cap of 30 million bpd. But while OPEC, and especially Saudi Arabia, chooses not to cut, the “recession of choice” continues.
Energy market participants need to harden themselves against these market realities. Lower prices drive a need for tighter cost control, which in turn drives a requirement for best practices in capital, maintenance and manpower spending. Lower costs will also emerge from better standardization, automation and optimization. In the commercial sphere, companies will need to be more open to financial engineering – inventory management, hedging and trading best practices.
Upstream producers will need to remain focused on costs. Despite efforts to curtail global carbon emissions, economics and demographics will drive greater oil demand until at least 2030. The world will continue to need more oil, both to meet rising demand and to infill and replace declining mature production. This can only happen if prices stay strong enough to sustain commercial production.
The key issue here is where marginal supply arises. Doubtless, there is more shale oil “out there” in Argentina, Colombia, Mexico, Russia, China and elsewhere. OPEC producers including Saudi Arabia, Iran, Iraq and Venezuela are sitting on enormous reserves of conventional and less conventional oil. Non-OPEC producers including Canada, Mexico, Brazil, Russia, Norway, Azerbaijan and Kazakhstan all have potential to significantly boost output. Cost savings from the current round of belt-tightening – the adoption of best practices and cost elimination – will better prepare non-OPEC producers for the long haul. Companies that reshape themselves to be “fit at $50” will have a future for decades to come.
Downstream, refiners also will benefit from the continued growth in demand, though this will increasingly migrate to the faster growing economies. The short-run benefit of lower prices will sustain transport fuel demand. If this becomes “base load”, it could continue to benefit refiners even after prices start to recover. In the medium term, demand in mature markets will contract as fuel efficiency and carbon emissions reduction programmes are implemented. Hybrid vehicles, biofuels and even ride-sharing will cut into conventional fuel demand.
Refiners in these markets will need to focus on flexibility and the exploitation of niches and trading opportunities. The market isn’t going to go away overnight, but it will prove challenging. Crude oil selection, on-the-fly re-optimization and proactive availability improvements will increase refiners’ flexibility. Tomorrow’s refineries will have highly trained and adaptable staff with technical and commercial experience to enable them to seek out opportunities for continuous improvement.
Global natural gas markets will also benefit from the eventual recovery in oil prices. We expect oil-linked prices in Asian markets to persist, though the strength of the linkages will depend on the scale of future seaborne LNG trade from Australia, North America and new provinces like East Africa. Higher prices will sustain development of new gas resources, many of which are already economic even at current low price levels. Economic shale gas will boost global supplies, while decarbonizing the power sector will boost global demand for natural gas. Capital cost discipline will govern the development of natural gas production, distribution and liquefaction infrastructure. Higher oil prices should help to support this development as better margins will boost the full cost recovery potential of new capital investment.
About KBC
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