In last month's column, we talked about the history of oil prices and the extreme volatility that has characterized global oil prices since the 1970s. We went from a flat-line graph from 1946 to 1973, and from then to the present day, prices have tended to ascend and descend rapidly, based mainly on simple supply-and-demand economics.
Oil prices and forecasts about future pricing are the focus of nine out of ten conferences and meetings I've attended the past six months, or at the least they're the elephant in the room. Therefore, let's delve into that issue a little more this month.
Conventional wisdom about the oil price downturn is that what went down quickly will recover just as fast. The most common scenario I hear these days is that prices will remain somewhat stagnant until mid-year when they will start to recover, and that oil prices will be in the $65 to $70 range by year-end. However, I seldom hear a convincing explanation as to why that is going to happen. As this is being written, the WTI price has dipped below $50 again, and Brent has dropped below $60.
Rusty Braziel, head of RBN Energy and a member of OGFJ's Editorial Advisory Board, recently delivered a compelling analysis on US natural gas and oil production during a Genscape webinar in February. He predicts that we could see WTI prices return to the $80 per barrel range by 2017, assuming the market responds correctly to energy demands. On the other hand, if resilient production by US operators keeps volumes growing while demand does not respond, we could see WTI prices trading in the $50 to $60 range or lower through 2020.
The latter scenario would not be good for the oil industry in North America - shale producers, in particular. Although oil economics vary considerably from play to play and even within plays, the widely accepted break-even price on a macro scale is about $65/bbl. If prices remain below $65 for the next five years, there will be a shake-out in the industry like we've never seen before.
Braziel says that if producers pull back on drilling and focus their existing rigs on their highest yield "sweet spots," we will see enough resiliency and efficiency to avoid harsh impacts on production growth.
Ole Hansen, head of commodity strategy at Saxo Bank, recently noted that there are some positive drivers that may help oil prices recover this year. Among them:
- a sharp reduction in the US rig count to a three-year low;
- major oil companies reducing future investment plans;
- a US refinery strike that has (temporarily, at least) given products a lift;
- shorts covering after short positions have doubled in the past month;
- a weaker US dollar;
- reduced supplies from Libya as fighting there intensifies; and
- investors piling $2.4 billion into energy exchange-traded funds (ETFs) since January 1.
Hansen said, "These are all relevant factors, and if maintained, they will help reduce the current supply glut. The major problem with a sharp rally at this relatively early stage is the fact that US shale oil producers have been handed an olive branch in terms of being able to forward-hedge their production."
In its 2015 crude oil outlook report, Morgan Stanley noted that the current low-price environment is a "self-inflicted crisis." Although analysts at the firm say that oil prices face their greatest threat since 2009, they expect a volatile 2015 rather than a "one-way trade."
"Without intervention, physical markets and prices will face serious pressure with the second quarter of 2015 likely marking the peak period of dislocation," says the outlook report, which added that "the coming oversupply is grossly exaggerated" and that only a modest fix is required.
Morgan Stanley added that the firm sees several factors that could contribute to a recovery, potentially as early as the second half of this year.
In an extreme scenario, said the analysts, shut-in economics could be required. The risk of material oversupply is high by 2Q15, they said, even though dislocations are unlikely to match prior crises. The only true floor in an oversupplied market, they said, is cash cost (estimated at $35/bbl to $40/bbl). The outlook concludes that the analysts expect OPEC intervention or lost production will prevent this, but the lagged fundamental impact and sentiment could push prices to these levels for a brief period.
Yikes! On the one hand, they say that the oversupply situation is grossly exaggerated and that only a modest fix is required. But on the other hand, they say shut-in economics may be required and that prices could fall as low as $35/bbl, albeit for brief periods.
With that kind of optimism, I would hate to read a pessimistic scenario for 2015 and beyond. The main point I agree with is that this is largely a self-inflicted crisis.
Although producers and vendors in the United States and Canada are feeling the brunt of low oil prices currently, this pales with what is happening in Mexico. That is the gist of a Feb. 4 discussion at the Woodrow Wilson International Center for Scholars, as reported by Nick Snow, Oil & Gas Journal's Washington editor:
"Mexico is a perfect storm - a serious production decline and a low oil price," said Duncan Wood, who directs the center's Mexico Institute. "It instituted modest energy reforms that look more like service agreements than production-sharing contracts. This might explain why only seven [international companies] have asked to see data rooms for the 14 offered contracts. There's a perception that the program has failed."
Continued low prices could force Mexico's government to make moves to make the program more attractive to investors, said Wood.
Well, at least that would be one good thing to come out of the current down market.