Tumbling oil prices wipe out speculative bubble
The nature of bubbles is that they burst. Fears of a global recession have brought oil prices down to levels not seen in a year, and effectively, burst the speculative bubble surrounding oil prices.
Lloyds TSB Corporate Markets’ senior economist, Nichola James compiled a report for Oil & Gas Review in which he analyzed the global outlook for the oil and gas sector and the current status of UK production. The following is the report.
Global outlook
The report finds current prices closer to levels justified by economic fundamentals and anticipates prices to hold steady between $80 - $100 a barrel in the medium term. According to the report, the economic rationale is that although global growth will slow, industrial and infrastructure development in emerging markets will underpin demand for oil and other commodities.
With high oil prices moderating demand in the Organization for Economic Co-operation and Development (OECD) area, total oil demand could weaken further over the medium term as global economic growth slows. However, prices are not expected to remain below the $80 a barrel level for much longer. In fact, they may even rise again, especially now that OPEC, which accounts for approximately 40% of global output, has cut production to shore up prices.
Meanwhile, non-OPEC production has been revised downwards, principally because of lower supply from the former Soviet Union, Latin America, and Asia (excluding China).
In addition, a draft release of the International Energy Agency’s World Energy Outlook finds that output from the world’s oil fields is declining much faster than previously thought. That means that the oil industry will need to invest more than expected.
UK production
In the UK, oil and gas production has declined in seven out of the last eight years. Last year, output fell by 1.7% and this is despite £11.5bn in new investment.
The industry has been kept profitable by high prices, which have up to now justified investment in the extraction of less accessible reserves, often by specialist companies. However, the long term UK production trend is downwards.
Financial ratios
This has also had an impact on financial ratios, with the FTSE All Share oil and gas index weakening, but remaining above the All-Share average, due to strong profitability of UK continental shelf companies and, until recently, soaring oil prices.
Bank loans outstanding to the UK oil and gas sector rose from £1.8bn in December 2007 to $3.6bn in June 2008, while funds deposited with banks were £2.9bn, down from £3.1bn at the end of last year. So oil and gas companies no longer hold a net cash balance, but a net liabilities balance of £0.7bn with UK banks.
“Global oil and gas companies have enjoyed record profits on the back of high prices in recent years, but the industry faces some difficulty going forward as production in old fields peaks and competition for untapped energy deposits intensifies. Lower output from maturing fields suggests that capital spending will need to continue rising as exploration and new field development holds the key to future sector growth,” said James.
“The IEA report is a further reminder that despite the fall in oil prices from $147 a barrel to about $65, oil prices are likely to remain under upward pressure in the medium term.”
Andrew Moorfield, managing director and head of the oil and gas sector at Lloyds TSB Corporate Markets added, “The UK oil industry is facing its biggest challenge in decades as the volume of extracted oil falls. Recent high oil prices have prolonged the operational life of North Sea fields and the search for untapped oil and gas has led to a considerable increase in investments. As a result, life expectancy of oil reserves has risen from 10 to 16 years since 2002.
“Over the longer term, I would suggest that firms will need to invest more in exploration in order to source new reserves. I forecast productivity in the North Sea to improve over the medium term.”