Oil Producers and Lower for Longer Prices – 1/21/16

The IEA report on the oil market for January paints a grim picture for oil producers. Mild winters in the US and Europe and uncertainty about the futures of China, Russia, Brazil, and other commodity-dependent economies have resulted in demand growth dropping from a high of 2.1 million barrels a day to a one-year low of 1.0 million. The outlook for 2016 of 1.2 mb/d growth also disappointed. The fall in demand growth coupled with supply expansion of 2.4 mb/d in 2014 and 2.6 mb/d in 2015, only declining significantly in December of 2015, has lead to oil prices falling below $30 for extended periods.

All major stock indexes show investors are worried about what is to come as energy companies and oil-dependent countries struggle with the sudden loss of revenues. The weakness of emerging markets, increased fuel efficiency, and the perceived limitations on central banks’ power to prop up growth has lead many investors and creditors to re-evaluate holdings related to energy firms. Moody’s and S&P have already begun reviewing companies for possible credit rating downgrades. Given the number of companies already straining under tightening credit lines, the increased costs of securing loans associated with lower ratings may help to accelerate defaults.

Oil output has been slow to respond even as stockpiles fill. Competition for market share among producers is a prime suspect as Iran begins its re-entry only a short time after the US boom in production began faltering. Iran is seeking to gain market share in China and Europe now that some international sanctions have been lifted as part of a recent nuclear deal. For it to make economic sense to buy from them, exporters of Iranian oil will need to cut prices and provide incentives which will likely drive prices even lower.

Among the many hurt by collapsed prices are several US states. Those that planned budgets around prices of $50 a barrel for the year face hundreds of millions of dollars in budget shortfalls. New Mexico, Wyoming, and Alaska are the only states whose budgets relied on oil-related revenue for over 10% of total revenues. Alaska is the most exposed with 79% of estimated operating revenue coming from oil.

Our neighbor to the North faces its own issues as Canadian heavy crude from oil sands falls closer to marginal operating costs and cuts to oil investment weigh on the economy as a whole. Like shale-oil in the US, Canadian oil sands is more expensive to extract. This fact lead many analysts to think that these higher cost producers would fold quickly with the 70% decline in oil prices. The reality of the situation is that output continues to increase even as investment spending is slashed thanks to facilities built before the collapse in prices which bring in just enough revenue to cover operating costs and spread out the impact of sunk costs.

Unlike the US or Canada, Venezuela cannot rely on the rest of its economy to make up for lost revenue. Since about 45% of budget revenues and 96% of export earnings are oil-related, the country desperately needs a price rebound to prevent a default in 2016. The lower quality crude sold by the country is already nearing the break-even production point. Investors are already expecting a default but if it were to actually occur then Venezuela will face the possible seizure of its oil shipments and the stoppage of already rare imports of necessities. The government of the country is currently in deadlock as the Maduro government attempts to stall a newly elected parliament dominated by the opposition.

Russia faces GDP contraction according to the IMF though it is improbable that the country will face significant turmoil in 2016. Despite dependence on oil to balance government budgets, the country has already weathered downturns due to sanctions and is relatively stable so long as the government can tap into reserves. If oil prices fall to $20 a barrel as some analysts have predicted, the most liquid fund the government can draw on will be emptied by 2017. A prolonged glut would force Putin to tap into a more illiquid pension fund, print money, or make deep cuts to previously exempt areas. Though the government has a number of options to tap into, the Russian people will suffer regardless and, with them, consumer spending. Real wages have fallen  over 13% in the last two years and  over 2 million more people fell into poverty last year in the nation of ~140 million.

While the general consensus is that oil prices can’t go much further down, there is much more debate on when it will go back up with recoveries projected for anywhere from 2016 to 2019. In the 2016 camp, the assumption is that oil most producers cannot survive $20 a barrel oil and $30 a barrel oil is too low to last the next six months. The reasoning seems solid when one considers the monumental cuts to new plant investment that have already been made would start having an effect this year. On the more pessimistic side, a 2-3 year slump as prices hit bottom and stabilize before rising again. Here the glut will end once inefficient suppliers are forced out and supply comes back in line with demand.

Personally, I don’t see oil recovering this year unless we see some drastic supply changes.

The resilience of North American suppliers has already surprised everyone who thought those producers would bow out when oil prices dropped so who’s to say they won’t hold on a little longer. After all they have already gotten more efficient to better dig their teeth into their bit of market share and technological advances will only ever favor cheaper extraction methods and, by extension, more robust profits. Those high cost producers have thus far only shown their willingness to bunker down in the face of adversity.

OPEC and the major non-OPEC oil producers have continued their own production spree with no sign of cutting output. One of the big oil exporters needs to totally collapse for there to be anything like a “quick recovery” from a market where supply growth is already more than a million barrels a day higher than demand growth with Iran set to add its half million this year as well.

On the demand side, I can’t think of a single upcoming world event or technological advance that would increase oil usage. Sure, the real pain from self-driving, electric cars is coming, at best, around 2025, but the focus on fuel efficiency and emissions reductions is happening now. Presidents of nations have never been so concerned with taking cars off the road or at least adding taxes to gas to knock off the benefit consumers could get from low prices at the pump.

Beyond environmentalism, people just don’t need to drive as much as they used to. Note the following: the rise of Uber-type car services; Amazon, and others, now offer grocery services on top of shipping pretty much every non-perishable item known to mankind to your doorstep (Drone delivery coming soon!); Facebook; Skype; and remote workers. These things are all examples of why people care less about driving each year. There is no reason to own a car if everyone else and their mother is suddenly a taxi. Few people actually enjoy shopping enough to want to drive every store or restaurant when you can have anything delivered to you. And seeing faraway loved ones and friends suddenly gets a lot less gas intensive when the internet offers instant contact. Finally, working from home is only going to get more common as the cost cutting implications become clearer meaning a lot less cars on the road during rush hour. These are just technology-based demand drains.

On the more traditional side, you have urbanization and rising incomes. Cities are only getting bigger and denser with time, both in number of people and number of businesses catering to those people. New Yorkers know all too well that having a car is more pain than pleasure when you could walk to the nearest shop faster than you could drive over and find parking. Bike and car sharing programs do so well in those areas because people only occasionally need them. In addition, rising incomes are letting people worry less about buying necessities and more about things like air pollution and global warming. Even China, where economic growth comes before all else, you see the government accepting the need to make city air breathable and tackle climate issues.

Ignoring for a moment the what I mentioned above as long-term problems for oil, the short-term issue for oil is that supply is out of line with demand. As I said before, the shale-oil and oil sand producers aren’t going anywhere without a fight; they’ll likely pop up again with new names once prices start looking good again since their assets don’t disappear as soon the companies start defaulting. Combine robust output with a China that has been riding an easy credit growth boom into overcapacity far too long for a soft landing and you get a prolonged glut. At least a year, probably two, of prices that make oil producers tear their hair out.

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