With the intensity of ancient seers examining runes, policy makers, analysts, and economists watch every squiggle of movement in the oil markets, scrutinizing rig counts and poring over the footnotes in annual reports to glean portents of the future. With crude oil now hanging in there around $36—a significant jump from January-February when it lingered below $30—there is a sense that the price of crude is recovering.
That makes sense—but it could still be wrong. The track record of oil-price predictions is not great, even among specialists. Very few people—possibly none—saw the run-up to $107.95 per barrel in June 2014 and the dive to less than $30 for much of February 2016. So I am not going to make any predictions. But I spend a lot of time talking with business leaders. Here are some of the questions I am hearing, and my answers. It looks like equities are following oil prices. Why is that?
In the past, falling oil prices were seen as a net benefit for the global economy, and stock values therefore rose when prices fell. Cheap oil is a form of consumer stimulus; the rule of thumb has been that every fall in price of $10 per barrelboosts GDP growth by 0.25 percent or more. Importers benefit a little more than exporters suffer.
This time, though, the market is seeing trouble in the form of a slowdown in China (a huge importer) and other developing markets, and generally unexciting global economic conditions. And this slump seems worse than usual for exporters. Russia and Saudi Arabia are both cutting public spending, for example, and diminished oil sales are another blow to struggling Brazil and Venezuela. Also, oil companies have cut back on investment sharply, with almost $400 billion in projects set aside. That has knock-on effects in terms of manufacturing. Finally, because energy companies are a major factor in equities, when they suffer, so do other stocks.
The stimulus effect of cheap oil has not vanished, but it is not enough to outweigh the general pessimism. In a sense, the fact that prices have fallen so far, so fast, is the problem: it hints at deeper worries about the global economy, worries that also show up in the equity markets. Why aren’t more oil companies going out of business?
Oil executives have learned from their experience of previous price swings, and many have hedged prices. In a sample by McKinsey of 25 US exploration-and-production (E&P) companies, around 30 percent of production was hedged through 2015, and about 15 percent was hedged through 2016. This gives time to wait out the cycle. The $400 billion in cancelled projects, and other cuts in capital investment, will also help many stay afloat. For their part, investors have proved willing to bet that prices will not stay low forever and have injected both debt and equity into the sector. There has been a great deal of bottom-fishing, particularly from private equity. Between November 2014 and September 2015, North American E&P companies issued more than $23 billion in equity, and an estimated $20 billion of asset sales has been injected in the system over the same period, according to Oil & Gas Financial Journal.
That said, there are only so many tools in the kit, and most have been used. Debt in many energy companies is trading below par, and prolonged low prices will certainly begin to drive some players into bankruptcy—sooner rather than later. “At $40 [a barrel], the [US] industry doesn’t work,” Steven Woods of Moody’s told the Financial Times. “Companies can’t earn an adequate return on capital.” Companies with weak balance sheets are vulnerable, and a number have either missed payments or publicly warned of bankruptcy. Why is production running higher than consumption?
Global demand growth dropped by half between 2013 and 2014, to 0.7 percent. At the same time, supply stayed strong because, in a bid to maintain its market share, the Organization of Petroleum Exporting Companies (OPEC) continued to pump lots of low-cost oil. Supply growth rose to a record 2.2 percent annual rate in 2014. Demand growth recovered to some extent, rising 1.7 million barrels in 2015, or 1.8 percent per year. However, new supply, both from OPEC and from non-OPEC projects that began when prices were higher, kept capacity growing, to a record 97.2 million barrels a day in the fourth quarter, according to the International Energy Agency. In 2015 and to date in 2016, the global market was oversupplied by 1.5 million to 2 million barrels a day.
In late February 2016, Saudi Arabia’s oil minister Ali Ibrahim Al-Naimi stated that cutting production “is not going to happen.” There will be a rebalancing, he noted, but it would be up to the market to sort it out. High-cost producers, such as those reliant on shale, oil-sands, or deepwater resources, cannot keep going in a low-price environment. “Inefficient, uneconomical producers will have to get out,” said Al-Naimi. “This is tough to say, but that is a fact.”
That sorting out is underway. Deepwater projects are prominent among canceled new capital projects. And US production has begun to decline (albeit slowly, so far), as low prices have taken some of the highest-cost assets out of production. Relatively high costs and aging assets are affecting fields in Colombia, Mexico, Nigeria, the North Sea, and Russia. All are hurting, and declines in production in these markets are going to add up. The US Energy Information Administration projects that non-OPEC production will fall by 400,000 barrels per day in 2016, which would be the first such decline since 2008.
With production exceeding consumption, inventories have been growing. At the end of 2015, commercial inventory for crude oil and other liquids reached a record 3 billion barrels (about 66 days of consumption) in the Organisation for Economic Co-operation and Development (OECD). This figure could reach 3.3 billion by the end of 2017. If inventories keep building, storage capacity will dwindle, though it seems unlikely to run out. But as inventories near “tank tops,” prices could collapse again. Where is the market is going?
Al-Naimi is probably right. Left alone, the market will balance demand and supply; that is what markets do. And if OPEC and Russia manage some kind of actual production freeze, that will happen faster.
One way or another, though, the factors that have been sending oil prices down for the past two years are changing. Drawing on the work of my McKinsey colleagues, here are two possible scenarios: Slow recovery. If the current price rally continues, and prices reach and stay at around $50, a slow-recovery scenario will become more likely. Stronger prices would encourage more production. Supply and demand would take longer to come into balance, probably in the second half of 2017.
Fast recovery. If prices linger around $30 to $35 per barrel, then recovery would be faster than in other scenarios as low prices drive out more production. For example, US tight-oil production would decline by an extra 300,000 barrels per day in 2016 and 1.5 million barrels per day in 2017, compared to the slow-recovery scenario. Sustained $30 prices would see supply and demand come into balance by the end of 2016.
Of course, there are many variables that could upset any scenario. With the easing of sanctions, Iran could return to the market in a big way; that has not happened yet, in part because of logistical obstacles, including the resistance of Saudi Arabia, but it still could. Another wild card is Iraq, where production could fall if the giant oil fields in the south are threatened. China’s landing could be a hard one, with a devastating effect on demand. On the other hand, low prices could trigger strong economic growth and lift demand. And so on. Is there a “black swan” scenario—something that is unlikely to happen, but would be a big deal if it did?
If prices decline further or stay low too long, it’s not impossible that, eventually, prices will fly up. That would happen if so much production gets shut down that spot shortages result, sending prices sky-high.
For consumers, this would of course be extremely unpleasant. But a fly-up could hurt producers, too. The risk to OPEC and other producers is that in response, governments could accelerate alternative kinds of production and also displace the use of oil altogether, curbing long-term demand.
In a sense, the only thing worse for OPEC than very low prices is very high ones—a counterintuitive idea that is often underestimated. “We need to remember that low oil prices are bad for producers today and lead to situations that are bad for consumers tomorrow,” OPEC Secretary General Abdalla S. El-Badri said earlier this year. “And high oil prices are bad for consumers today and lead to situations that are bad for producers tomorrow.”
88E Price at posting:
6.7¢ Sentiment: Hold Disclosure: Held
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