What Goes Down, Will Go Back Up

January 2016 Sarah Miller
January 2016 Sarah Miller

Oil prices will go back up. It's a question of when, not if, for the simple reason that prices are well below full replacement cost for a big chunk of needed supply. In the selling frenzy that has recently gripped oil, commodity and equity markets worldwide, it's easy to forget the evident fact that sub-$40 per barrel prices are not sustainable because they don't cover costs. Indeed, by undermining corporate financial viability, this very frenzy makes it likely that the price upturn will come sooner and be sharper than it would have if crude prices had stayed in the $40-$50/bbl range. This is cyclical commodity market behavior with a vengeance. Unfortunately for the oil industry, this extreme cycle is coinciding with an effort to wean the world off fossil fuels, and any big oil price spike, even if it's short, could prove more devastating over the long term than the current price plunge.

It's a common human trait to project the present into the future, even though change is the one reliable feature of the world as it actually operates, ensuring that straight-line forecasting off recent trends is generally wrong. The suggestion that oil prices will remain low for a long time is likely to prove an example of this truism. Of course, prices have already gone lower and stayed there for longer than many expected. But that's because in an impatient world, it's easy to forget how long it takes an industry as large and long-term in orientation as oil to alter course. Expectations were also shaped by the fact that, in similar price reversals in earlier decades, Opec would have stepped in by this point to right the ship.

This time, there's little if any prospect that Saudi Arabia will change course from its active pursuit of rising market share over price. What is finally appearing, however, is ample evidence that lower non-Opec production is on the way, first in the US and then in the wider world where even bigger, slower-moving projects hold sway. This is clear for all to see. Where argument is centered is on how many more months or even years it will take to pull production back below demand so that an enormous stock overhang can be worked off. The Saudis and their allies maintain this will happen in 2016. Others, including Oil Market Intelligence, suggest it will be 2017 or later before production drops enough to intersect with demand (OMI Dec.15'15).

Market Psychology

While valid on its own terms, what this debate ignores is that markets don't wait to change direction until a clear return to some elusive balance. At some point well before the inventory overhang disappears, and perhaps even before supply comes down enough to match demand, sentiment will shift. Probably abruptly and possibly sharply.

The shift could be set off by news of an accelerating decline in US production -- something that was looking increasingly plausible even before sub-$40/bbl prices, and all the more so now. Hedging of oil sales and willingness of lenders to roll over debt were two big factors underpinning US independent producers in 2015. Both look much weaker in 2016. The percentage of expected oil production that is hedged is now well below 30% for most independents, and the oil prices on those hedges are presumably much lower than they were last year.

Nearly one-quarter of some 800 US energy companies are at "high" or "very high" risk of bankruptcy at the moment, according to Rapid Ratings, which uses a system of 73 financial ratios to assess risk (EIF Jan.6'16). This year's plunge in oil equity prices, which followed an even more vicious sell-off in the so-called "high-yield" corporate bond markets that had proved so supportive of smaller oil firms earlier last year, makes prospects for these companies even worse. Of course, someone else could snap up the assets of bankrupt companies, but disruption is inevitable and buyers may not be willing to take on and operate higher-cost producing properties in the current oil-price environment.

Outside the US, decisions to start new upstream projects ground to a halt in 2015 and will probably remain in deep freeze this year. A study published in December by Houston-based energy investment bank Tudor, Pickering, Holt finds that delays or cancellations last year in around 150 projects worldwide, based on 125 billion barrels of oil equivalent, could slice up to 19 million barrels per day off earlier expected production in the years to come. The full force of that probably won't be felt until 2017-19, but a looming gap in supply will become increasingly evident to analysts -- and therefore oil traders -- well before that.

Geopolitical events are also in the running to be a factor luring bulls back out into oil markets. Oil prices spiked by more than 4% immediately after Saudi Arabia announced on Jan. 3 that it was breaking off diplomatic relations with Iran, providing a reminder, albeit fleeting, of what a political risk premium looks like. The bears quickly grabbed back control of oil markets, and prices moved lower than ever. No evident notice was taken when armed men set fire to a state Saudi Aramco bus in the oil-producing and largely Shiite Eastern Province last Tuesday, following the execution of Shiite cleric Nimr al-Nimr just days earlier, and market commentators suggested that all increased tension between Iran and Saudi Arabia means is that Opec is even less likely to act to stop the price rot (EC Jan.8'16).

Some headline grabbing upheaval in the Middle East over the coming months could well have a more durable impact on prices, however. This could happen either because events actually affect oil output or, more likely, merely because they combine with falling non-Opec production to pull traders' attention back to the risks inherent in the ever-greater reliance on Mideast oil that the price collapse is ensuring.

Author, owner of Prometheus Wealth Management and admitted contrarian Michael Kamperman recently argued in a commentary on the Seeking Alpha financial website that there should already be a large political risk premium on oil but there isn't, most likely because of the incentives for traders of short-term profits in a falling market. "The oil market is being driven by outsized returns on the short side of the trade. As long as prices stay down more companies will go bankrupt leading to more profits for the shorts. There is currently no focus on maintaining the balance between supply and demand over the longer term in the oil markets. This is why there is no geopolitical risk premium."

More Vertigo, Not Balance

Whatever the spark, when markets do turn, it's unlikely that they will edge gradually up to a sensible and "new normal" range, whatever you think that range should be based on your assessment of the replacement cost of needed production. They are more likely to overshoot on the upside just as they are undershooting now on the downside, thereby laying the groundwork for yet another collapse -- all to the detriment of public confidence in oil and to the benefit of renewable energy sources, with their steady and generally falling price tags, and the electrification model as a replacement for fossil fuels.

One possible way to avoid this would be for Saudi Arabia to now take on a completely reversed version of its former role, upping production and eventually capacity in order to prevent this kind of industry life-shortening surge in oil prices (WEO Jan.7'16). This could provide a route out of the commodity cycle trap if the kingdom is willing to invest in more upstream capacity. However, the much greater global dependence this implies on low-cost Middle East oil enlarges the geopolitical risk facing the industry, potentially undermining the effectiveness of such a Saudi strategy.

Sarah Miller is editor-at-large at Energy Intelligence and former editor of Petroleum Intelligence Weekly, World Gas Intelligence and Energy Compass.


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