OUTLOOK ’17: Oil price stickiness may last on strong liquidity and weak fundamentals

LONDON (ICIS)–Subdued global oil production may keep the oil price above $50/bbl, although probably below the $55 mark. The final OPEC production-curbing deal, if implemented and properly verified, will help rebalance the market. However, it may not significantly affect supply and demand fundamentals.

Both Saudi Arabia and Russia have kept producing at record-high levels, and the US will not participate in any collective supply agreement. Meanwhile, higher-breakeven shale producers prepare to return to the market.

After an inflexion in Q1 2017, world liquids production will resume growth from Q2 2017 on a shallow-rising trend, according to the Energy Information Agency (EIA).

Sustained demand from Brazil, Russia, India, and China (BRIC countries), notably on increased power generation and the mobility revolution in India and China, will keep in line with this increased supply.

World demand for refined products, however, may not pick up until the global economy improves. China, which remains central to it, currently exhibits a smoothly decelerating GDP (est. 6.5–7% in 2017), a massive debt overhang, and a fading effect from the past years’ investment stimulus.

Persistently low interest rates have flooded the fixed-interest markets with too much liquidity, resulting in turn in a “volatility trap”, that is, a situation where short-term movements on the markets rule over investors’ decisions and jeopardise steady, long-term upstream investments in hydrocarbons.

EXCESS LIQUIDITY PERSISTS

At the macroeconomic level, energy has been lagging the other commodity markets because increased volatility has put downward pressure on investors’ returns.

The combined effects of negative interest rates and lasting quantitative easing have resulted in a liquidity glut, with a lot of sub-optimal investments earning poor returns. While this may be good news for emerging energy markets offering higher yields, it also upholds a “volatility trap”, subjugating investors’ decisions to the market short-term movements.

This liquidity has so far defied all the US Federal Reserve’s (Fed’s) attempts to restore credit bullishness. Currently, the short-term interest is the only rate over which the Fed has kept a modicum of control, and it is negative. As economist Lena Komileva from G+ Economics recently put it, “the risk-free rate has become the rate-free risk”: investors must pay to park government bonds.

Quantitative easing is generally intended as a short-term solution because perfusing the economy for too long puts downward pressure on the domestic currency and feeds inflation. Should the Fed decide to cut it off abruptly, this may cause a “taper tantrum”, that is, a mass panic of investors drawing their money rapidly out of a bond market that already suffers from low yields.

A tightening of US credit seems unlikely in 2017, essentially because of the Fed’s overall dovish stance and reflationary bias. The US federal fund rate is projected to end at 1.1% at end-2017. In a speech at the Economic Club of New York , the Fed’s vice-chairman Stanley Fischer recognised the possibility that low long-term interest rates can be a signal that the economy’s long-run growth prospects are dim.

Figure 1 – Distribution of participants’ projections for the change in real GDP in 2017

Source: US Federal Reserve, Minutes of the Federal Open Market Committee 20–21September 2016

UPSTREAM INVESTMENT STAYS WEAK

At the microeconomic level, the head of the EIA, Adam Sieminsky, said  that the lack of upstream investment over the past couple of years or so might be a problem five years from now. This confirms and amplifies the findings of a Deloitte study  earlier this year where the accounting powerhouse estimated that the global upstream industry would need to invest at least $3,000bn in 2016–20 to ensure crude oil long-term sustainability. With an average 6% replacement rate and no Ghawar giant oil field in sight, oil supply might feel the years of underinvestment as early as 2025.

The silver lining is that capital expenditures (capex) from several exploration and production companies (E&Ps) increased during Q2 2016, essentially on higher crude oil prices and hence, larger cash flows. This suggests that prices now hovering above the $50 mark may help maintain capex commitments and mitigate production declines, especially after the big, general balance sheet clean-up of the beginning of the year and OPEC’s return to market management.

Some oil will also be displaced by the rise of electric vehicles which, according to some predictions, may cost the same price as their internal combustion counterpart in 2022 . This may entail the displacement of 2bn bbl/day of oil, which would be enough to create another, long-lasting supply glut.

However, it is unclear how this may play with the extra power demand, as the substitution effect from producing more electricity will merely displace oil consumption from one sector to another. Regardless, every technological breakthrough by Silicon Valley blue-chip companies like Tesla is diverting funds away from upstream investment, not to mention the downward pressure on refined products markets – gasoline in the first place.

LARGE PRODUCERS TIGHTEN COSTS

On the geopolitics side, the picture may look slightly more blurred and complex. Three years into its all-market stance, Saudi Arabia has tentatively reverted to supply management to lift prices, while producing at full throttle to retain market share.

The Kingdom is now feeling the full effects of its earlier laissez-faire policy in terms of fiscal deficit and slower GDP growth, not to mention the melting foreign exchange reserves. Besides, Saudi Aramco may have found good reasons to try to fetch a higher oil price for its upcoming IPO.

While the traditional role of Riyadh as a discipliner still worked to some degree – flooding the market with cheap oil to force out the competition, some producers have radically improved their drilling economics to move down the production cost curve and come back to the market at much lower benchmark prices.

The US is one of them. US shale E&Ps will likely fight for market share if prices stay at or above $50/bbl, in particular from prolific basins like the Permian, which not only remains profitable, but seems to drive an increase in merger and acquisition (M&A) activity.

According to IHS Markit, spending in the Permian might be close to $20bn year-to-date, including 24 M&As larger than $50bn in size. Last October, SM Energy closed the acquisition of nearly 25,000 net acres contiguous to the properties it already owned in the area for $1.6bn, and the debt-ridden Occidental Petroleum paid $2bn cash for 35,000 acres.

Nearly all wells currently in operation in the US are now horizontal, suggesting that drilling economics there have spectacularly improved on longer laterals, and generally in well-known areas where costs of production are under tight control.

Russia is pumping oil at post-Soviet record rates, recently claiming that it may keep ramping up production, although this might be from high-cost – hence uneconomic – areas such as the Arctic.

Although the country has now pledged to commit to production caps, its output has increased by an approximate 150,000–200,000 bbl/day since the beginning of the year.

Russian hydrocarbon production has benefited from a weak rouble that reduced drilling costs and taxes. The country also introduced its own Urals futures at the Saint-Petersburg Mercantile Exchange (SPIMEX) on 29 November, following a decade-long attempt to price its own Russian crude domestically.

This might be a first step towards the “de-dollarisation” of Russian commodities. However, given the country’s huge budget deficit, the Kremlin may have to convince investors that its intent goes beyond achieving higher prices, and the political environment will be the biggest hurdle to overcome.

SOME SOFT SPOTS IN FUNDAMENTALS

China also crystallises a few concerns for oil markets. The country is currently registering a smoothly decelerating GDP (est. 6.5–7% in 2017), combined with a massive debt overhang, and a fading effect from the past years’ investment stimulus.

After Beijing granted independent Chinese refiners their first import licences in the summer of 2015, the so-called “teapots” have become one of the most sought-after oil market, mopping up part of the global excess supply.

At current prices, China – whose high-cost production fell to a trough of 3.89m bbl/day in September – will keep importing lower-cost oil from Africa and the Middle East to gradually replace coal (of which it is the world’s first producer and consumer).

Lastly, Venezuela’s PDVSA has run into deep financial troubles, which put a bit of bullish pressure onto the markets by constantly threatening to wean US refineries off one of their main sources of supply.

Venezuela produces a type of heavy sour crude that fits well into the distillation curves of the US Gulf Coast refiners. According to the EIA, about 30% of their crude imports come from that country in order to satisfy refinery requirements for its subsidiary CITGO and other term arrangements.

Ironically, PDVSA, the national oil company has been importing lighter material from the US to be used as diluent with Venezuela’s heavier production at its refinery in Curacao.

Beyond the possible disruption to the US downstream sector, any default would also knock off a few bond holders. Hence, their recent reluctance to exchange more than $5.3bn of PDVSA’s outstanding notes maturing in 2017 for longer-term securities.

The country has again miraculously passed the peak of alert, but its future will influence global oil production and supply from Latin America in particular. The resulting short-term bullishness may, in the longer term, boost US domestic production and in turn, put downward pressure on prices, especially if the recent-elect US president Donald Trump decides to verge on the protectionist side.

Image source: Design Pics Inc/REX/Shutterstock

By Julien Mathonniere