5 Negative Factors For Oil Prices

It has been a rough 2 years for forecasters of crude oil prices. Essentially no one saw the 2014 crash coming, and everyone looked on in surprise as a barrel of crude oil tanked, from over $100 to less than $30. After the crash, many forecasters expected a speedy recovery driven by bankruptcies in U.S. Shale, only to be left surprised again by the slow pace of the structural adjustment of supply to demand, causing the crude oil price to remain in the $30 to $50 per barrel range much longer than anticipated. And now, just as everyone has begun forecasting “lower for longer”, crude oil seems to be breaking through the $50 per barrel range in response to the announcement that OPEC and Russia intend to cut production.

All these surprises did not happen because crude oil price forecasters are “quacks” and “charlatans” who don’t really know what they are doing. Rather, the issue is the large number of real world factors that impact the crude oil price – economic growth; interest and exchange rates; demographics; global, regional and local politics; weather conditions; et cetera – and the general unpredictability of these factors. On top of this, the global economy’s financial markets have made it possible for the crude oil price to move disconnected from these factors. Speculator sentiment can make the crude oil price move in anticipation of an event, that is before something has actually happened, and by more than is justified by the event (“overshoot”).

Clearly, this makes crude oil price forecasting exceptionally difficult. That does not mean, however, there is no value in doing it.

If it hadn’t been for crude oil price forecasts the world wouldn’t have known about many of the factors impacting the crude oil price. The reconciliation of the forecast and the actual price of crude oil often results in learning about new things with implications for the crude oil price, new factors which had not been considered before. U.S. shale’s ability to innovate is a recent example. In other words, while crude oil price forecasts might not always be accurate, if done well they do always support development of critical insights into the crude oil market.

That this enhanced understanding of how the world of crude oil works has not resulted in increased accuracy of crude oil price forecasting, is because the world continues to increase in complexity. New factors continue to be added to the pool of factors of affecting the crude oil price, often times upsetting the effect of established factors. In a business with a long term horizon such as the crude oil industry, where exploration, development and production can all take years, added complexity substantially adds to uncertainty. The oil industry has developed management techniques to deal with this uncertainty, such as scenario planning and strategic risk management. Crude oil price forecasts are a critical input for these tools to function, which means that crude oil price forecasting is an impactful value creation and preservation tool.

With the value of crude oil price forecasting firmly established, we will continue to monitor the global crude oil market to assess how events and trends will be impacting the crude oil price. At present we are bearish for crude oil, as we believe the following factors will be driving the oil prices in the short to medium term.

Downside Risks

OPEC

The countries united in OPEC at present account for approximately one third of global crude oil production, giving the OPEC cartel significant ability to influence crude oil supply and market sentiment. The recent announcement of an agreement to cut production sometime in November 2016 effectively signaled a change in course. Since 2014 OPEC’s strategy had been to “protect market share”. Now it seems to be returning to a price management strategy.
OPEC’s ability to deliver on this strategy remains doubtful. The allocation of the announced production cut amongst the OPEC members still needs to be agreed, for example. Since essentially all are struggling under the low oil price, this will not be easy to achieve. The reported disagreement amongst OPEC members on production statistics signals a behind-the-scenes disagreement about next steps.

If an agreement is established, the cartel’s history of members cheating on formal agreements, leading to actual production coming in higher than formally agreed, will need to be managed. Amongst the tools historically used by OPEC member states to avoid being impacted by an agreed cut is increasing production before the cut becomes effective. As OPEC reported record production of 33.6 million barrels per day during the month of September 2016, at least some of the OPEC countries appear to have resorted to this tactic this time round as well.

There is also the question of how much exactly an agreed production cut will impact the number of barrels supplied to the international markets. For example, during summer Saudi Arabia uses over 1.0 million barrels of crude oil for power generation, in order to deal with peak power demand associated with air-conditioning. Now that summer is over it can easily afford to lower production by 0.5 to 0.75 million barrels per day since that would not affect the number of barrels of crude oil it offers for sale to international buyers.

The crude oil price seems to have already factored in an effective implementation of OPEC’s stated intent to reduce supplies. Consequently, we don’t expect “OPEC success” in November to raise the crude oil price much higher. On the other hand, if OPEC fails to deliver a real reduction in the number of barrels it supplies to the global markets, this could push the price back down to the $45 level.

Global Economic Growth

The two-way relationship between economic growth and energy demand, and by extension crude oil demand, is well established. As economies grow they tend use more energy. Conversely, the availability of (cheap) energy enables economies to grow. For this reason global economic growth forecasts feature prominently in crude oil demand forecasts.
The fact that global economic growth has consistently been overestimated the last few years therefore substantially contributed to current supply glut. In essence, the crude oil industry invested billions in anticipation of demand that never materialized.

A consensus seems building amongst economists that in the short to medium term, global economic growth will be less than what the world got used to in the post WWII period. The IMF, for example, has warned for a coming period of mediocre growth, under the influence of factors that according to some are not easily resolved and according to others can not be resolved at all.
But even mediocre growth is under threat, and thus also even the least optimistic of crude oil demand growth forecasts.

Many of the globe’s key economies are struggling. In Japan Abenomics are by now considered a failure. In Europe, where the euro debt crisis remains lingering, Brexit has raised additional concerns about the future of an economic growth that already was “sluggish” at best. Regarding China concerns remain that the real growth slowdown is much worse than the official statistics indicate.
Hanging over all of this like a thick dark cloud is a global debt which has reached record levels. As long as interest rates globally remain at their current record low levels, this will not cause any issues for economic growth. But in today’s a low growth environment an increase in rates obviously would, which would have a knock-on effect on global crude oil demand. In China the debt issue seems to be a particular concern at the moment.

As energy efficiency is becoming more and more a focus area of governments around the world, reducing the impact of economic growth on crude oil demand growth, there is a high probability that crude oil demand growth will continue to disappoint, which would keep the price locked at around $50 per barrel, the price of the marginal barrel at the moment.

Chinese Oil Demand

China was instrumental in the crude oil supercycle that lasted from 1999 to 2014, as during that period China’s crude oil demand grew by an amount equivalent to the total oil consumption of Japan and the United Kingdom. The country is now the world’s largest crude oil importer.
Although growth of the Chinese economy has slowed down over recent years, Chinese crude oil demand has continued to grow at the previous pace. This is because China has been using the low oil price environment to fill up strategic and commercial storage. According to some, China has been buying 0.5 million barrels per day on average in 2015 and 0.9 million barrels per day on average in 2016.

Obviously, this demand can not last forever as at some point China’s storage capacity will be full. It is not known exactly how large this capacity is, or how full it is at present, but as the buying associated with strategic storage is slowly phased out, China’s crude oil imports will stop growing or even decrease, taking the crude oil price down with it.

Technological Innovation & Process Optimization

At the beginning of 2015, most crude oil price forecasts assumed US shale to respond quickly and lower production, since the typical shale production cost at that time was substantially higher than the crude oil price. This expectation never materialized, however. Total US crude production dropped by just 0.8 million barrels per day between April 2015 and May 2016, because the US shale players were able to drastically lower their cost of operation. In part through renegotiating contracts with suppliers and service providers, but also through innovating and optimizing their processes.

While some of the savings from contract renegotiations will be undone during the upcoming period, shale innovation should be expected to continue to lower the production cost. In more conventional areas a similar trend to drive operating costs down through innovation and process optimization can be witnessed, with some success stories already. Effectively, this will result in increased crude oil supply at every possible price range (ceteris paribus), and thus put downward pressure on the crude oil price.

Automotive Revolution

Crude oil has been a remarkably stable industry for most of its existence. While the technologies applied to finding, developing and processing crude oil have indeed changed substantially, the products itself was never seriously challenged by outsiders, i.e. by new solutions for humanity’s energy need. Until recently, that is.

Under the influence of factors such as emission control regulation, changes in consumer preferences, digitalization and urbanization, the auto industry is presently going through transformation change. One of the changes is a move away from the internal combustion engine towards electric and fuel cell vehicles.

As some two thirds of crude oil demand is linked to transportation, this could have far reaching consequences for the crude oil industry, deflating global crude oil demand by millions of barrels per day as soon as early as 2030.

Upside Potential

Opposite these substantial downside risks for the crude oil price we see just two factors that bring an upside potential, namely Upstream underspending and geopolitical risks.

Upstream Underspending

Major cutbacks in exploration spending following the 2014 crude oil price collapse have resulted in new crude oil discoveries dropping to a 60 year low in 2015. On top of this, spending on production maintenance for mature fields has also been greatly reduced, the first effects of which are beginning to show in the production numbers.

The global average for natural decline rate for mature fields has been assessed at around 6 percent annually. Therefore, unless spending on exploration and mature field production maintenance recovers during 2016 and 2017, there is a substantial chance that 2 to 3 years from now the crude oil market will return to a state of shortage, which for an intermediate period at least could push the crude oil price up to $80 per barrel, the price needed to spur on investment in long-cycle projects such as deepwater, or possibly even higher.

Geopolitics

The war in Yemen is a geopolitical conflict with the potential to impact the crude oil price in the short to medium term, for two reasons.

Firstly, Yemen itself borders a key transport route for crude oil. Some 5 million barrels of crude oil pass through its Bab Al Mandab every day. Recently, the area has been drawn into the conflict. A worst case scenario for the conflict is a further escalation which closes the Bab Al Mandab for commercial shipping entirely, forcing crude oil transports from the Middle East to Europe and the Americas to take the much longer route around the Cape of Good Hope instead of through the Suez Canal.

Secondly, behind the war in Yemen is a conflict between Saudi Arabia and Iran. It is not impossible for the war in Yemen to spill over into other areas of the Middle East, which, at 31 million barrels per day, is home to around 35 percent of global crude oil production.

Other geopolitical events with a more remote likelihood of impacting the global oil markets are Iraq, in particular the battle for Mosul which is of course a key oil producing area, and the battle against ISIS, in particular in Libya where the group has been threatening the major oilfields in the eastern desert of the country.

By Andreas de Vries & Salman Ghouri for Oilprice.com

Note: Article was originally published in OilPrice and later over twenty websites around the world published it.

Dr Salman Ghouri is an Oil & Gas advisor with expertise in global / regional long-term forecasting, macroeconomic analysis and market assessments. He has developed Oil & Gas industry analyses in support of industry leaders, investment bankers and politicians, and has over 80 publications in international industry journals to his name.

Andreas de Vries is a Strategy Consultant in the Oil & Gas industry, supporting companies to not only develop strategies for success but also execute them.

Why Oil Companies Must Look Beyond Oil To Survive

Note: this paper was originally published in Oilprice on August 11, 2016.

Persistently low oil prices have had a devastating effect on the economies of all major oil producers/exporters who are accustomed to a price regime of over $100/b. The lifting of sanctions on Iran and its ability to quickly ramp up to pre-sanction (2012) levels of production and exports has made the market even more liquid and exerted downward pressure on oil prices.

Economic survival and grabbing market share – self destructive

Suddenly when oil prices collapsed, the major oil producers and exporters found themselves in a challenging situation, as falling oil revenues were not sufficient to balance government budgets. In an effort to sustain their economic growth, while finding it difficult to keep the economy growing at the desired pace; they had to take some unpopular measures. Austerity measures, downsizing, delaying of some major projects, removing energy subsidies, and draining of sovereign wealth funds are some of the many immediate measures that oil producing/exporting countries are undertaking to cope up with falling oil revenues. The question is for how long they can survive if such a unique situation persists over an extended period of time?

OPEC and Non-OPEC need to collaborate

Oil prices are likely to remain below $50/b for at least a year or so; unless all stake holders, including OPEC and major non-OPEC producers cooperate on a production freeze/cut. This is a difficult task and even harder to implement. The reason being that all oil producers/exporters are in a catch-22 situation. Almost all oil producing/exporting countries are facing a dilemma of a budget deficit due to deteriorating oil revenues. Each producer is trying to produce/export more by offering discounts to grab the market and trying to lift oil revenues to narrow-down their budget deficit. For example the headline: Saudi oil output sets record despite global glut signals that is, there is a silent war going on among oil producers/exporters to produce and sell more in an effort to sustain/revive their sluggish economies. Their individual actions continue to push up the already overflowing inventories and further exerts downward pressure on oil prices.

Oil Demand and Regulatory Reforms

On the global oil demand front the international agencies’ forecast is always associated with strong oil demand in Asia and more particularly linked with China and India. For example, BP and IEA respectively predicted that non-OECD Asian oil demand is likely to increase by 15 and 11 million bpd during 2015/2035.
It is quite possible that these forecast may not materialize as predicted due to so many on-going initiatives in both the countries. Such optimistic forecast may lead to overinvestment in the upstream sector, further dis-balancing the oil market equilibrium in the medium to long-term.

In an effort to curb pollution, a number of ongoing regulatory and legislative initiatives in China and India are taking place. For example, total vehicle sales in China grew by 4.7 percent in 2015 to 24.6 million, down from 6.9 percent sales growth seen in 2014. This is partly contributable to weaker GDP growth, but mostly due to certain initiatives such as quotas imposed by the Chinese government in cities such as Beijing and Shanghai where aspiring car owners must enter a ballot to get a license plate. Other measures include alternative day driving restrictions and progressively improving average fuel consumption standards.

Rapid penetration of electric vehicles in China is yet another factor that could dent the projected oil demand growth. India’s oil demand is expected to grow as the ownership of vehicles is still expected to increase significantly. However, an Indian court handed down rulings in an effort to control air pollution in urban areas in particular. Examples of this are a ruling by India’s Supreme Court in 2015 which results in banning the sale of luxury diesel cars in New Delhi and the National Green Tribunal, a special environmental court, which directed the government last month to ban all diesel vehicles in the capital that are more than 10 years old.

Structural changes in auto-industry

The higher oil prices and environmental challenges in the past have motivated the auto-industry to revolutionize and move away from over a century old Internal Combustion Engine (ICE) dominance with Electric Vehicles (EVs) and Fuel Cells Vehicle (FCV). What does it mean to oil companies? Do oil companies need a new long-term strategy to remain successfully in the business? Or live with a status quo strategy? If they ignore such a threat and do nothing it may undermine their long-term objectives. One should not ignore the fact that more than 72 percent of oil demand is mainly associated with transport sector and out of this over 80 percent has been linked with road transport. Speedy penetration of EVs will certainly displace sizeable oil demand in decades to come and could be detrimental for the oil industry.

Until recently, the oil industry perhaps is not giving any attention as what is happening around the auto-industry. However, a recent announcement of almost all the ICEs car manufacturers’ plans of moving away from ICE to EVs while some companies are planning to completely stop manufacturing of ICEs beyond 2050 should be alarming and eye opening for oil industry.

Volkswagen and Audi are aiming for EVs to make up 25 percent or more of sales by 2025, while Mercedes is about to unveil an entire fleet of electric vehicles, other automakers Hyundai, BMW, GM, Chevrolet Bolt, Tesla, and others also unveiled big plans.

In addition, the introduction of semi and fully autonomous cars and drones to replace domestic delivery will surely have a substantial impact on global oil demand. What this paradigm shift means for oil companies? Surely rapid penetration of EVs will displace sizable oil demand in road transport which accounts for major chunk of oil consumed. Author and Andreas de Vries in their recently published the article “Wake up call for oil companies: electric vehicles will deflate oil demand” predicted that under the reference case the penetration of EVs will displace 13.8 million bpd by 2040 and under the high case it could reach 39.5 million bpd.

To defend the oil industry from complete disintegration, is the current lower $50/b oil price regime part of oil and gas companies’ strategy to discourage the speedy development of EVs industry? Or rather is it due to technological innovation or due to self destructive policies for individual survival (grabbing market share) rather than protecting the industry? Some smart companies already expanded their old philosophy of being purely oil and gas business towards energy business including development of renewables. I think sooner or later most oil companies will need to develop a new strategy before it is too late. Those sticking with the philosophy of “old is gold” could find themselves on other side of the fence. 

 

 

Implications of structural changes within & across industries on oil & gas industry

 

 

 

 

The global energy landscape is expected to change – led by renewables, undermining the role of coal and natural gas in power generation. While structural changes in auto-industry will have devastating effect on the global oil demand during the next few decades! How will it all affect the destiny of oil and gas industry?

I can recall, it was the month of September in the year 2012, when I last filled up gasoline in my car with a price tag of $3.81/gallon ($57.15 for 15 gallons) in Dallas, Texas. The higher gasoline prices during the past 3-4 years had put severe financial stress on monthly budget for an average American household.  

Unfortunately, due to a car accident I ended up with multiple injuries and went into a deep coma (

Note: *The story is fabricated to set the base for discussions).

On June 16 2014, suddenly, I woke up from coma and found myself in the hospital bed. After a week of being under observation, the hospital discharged me. While we were driving home, my wife stopped at the gas station and I started to recall past. When she filled up the tank, I asked her how much she paid for the gas and she told me a total of $26.49. She further added that gasoline was now selling at $1.76/gallon. I was shocked to hear this as gasoline used to be close to four dollars a gallon as I recalled.

Asked my wife what had happen during this period? In her layman understanding she said that she has been hearing about something related to US shale oil boom that caused oil prices to collapse. Being in the oil and gas profession I know about shale oil and I recalled that in 2012 I wrote an article entitled: “The US unconventional oil revolution: are we at the beginning of a new era for US oil?”, published in European Energy Review on June 18, 2012, where I had predicted such thing to happen, and my forecast in 2014, turned out to be true.

As I slowly recovered from coma, I returned back to my normal life and started carrying out my everyday research and forecasting. During the period when I was in coma, things had changed quite a bit. Oil prices came down from over $100/bbl to below $30/bbl and lately revived close to $50/bbl. What causes collapse of oil prices and what is the future prospects of oil and gas industry were some of the questions on my agenda for research. Firstly, what happened in the past and secondly what are likely to happen in the future?

Three things are simultaneously happening in the process. Firstly, additional barrels of unconventional oil that were there but unexploitable in the past due to low permeability and technological constraints (including reserves in new frontiers/deep water, and shale gas condensate) are now exploitable. In the process US shale oil production increased from 1.2 MMBD in January 2007 to 5.6 MMBD in April 2015. Lately, it declined to 5.06 MMBD in March of 2016.

What causes shale oil to boom?

Persistent higher oil prices allowed the unconventional shale oil industry to grow and nurture and even counter the regime of declining oil prices. This was possible due to technological advancement (horizontal drilling, multi-fracturing, improved drilling efficiency and completion, supporting higher productivity per well, including well configuration and concentrating towards the most productive areas of the Basin).   In the process, Estimated Ultimate Recovery (EURs) in some of the basins also improved and reached 50-60% during the years 2015-2016. Consequently, oil productivity per rig in all seven basins recorded phenomenal improvements. For example, oil productivity per rig for Eagle Ford was 42 b/d in January 2007 which increased to 829 b/d by March 2016 – about 20 fold increase. In this learning curve, the total number of rig count peaked in October 2014 at 1257 and thereafter we saw a gradual drop and by March 2016, down to 307.  Continuous decline in break-even costs and in some of the basins breakeven cost down below $30/bbl that kept a number of companies continue producing despite a weaker oil price environment. 

Structural shift in automotive industry 

Secondly, over 72% of oil is predominately consumed in transportation sector (road, air, rail, sea, etc). Over 80% has been associated with road transport. Therefore, any revolution in auto-industry can disrupt the future global oil demand, thereby affecting the oil company’s growth.  During the last decade or so structural changes have been taking place in the transport sector. Over a century internal combustion vehicles (ICs) are in the process of being replaced by penetration of electric vehicles (EV), fuel cells vehicles (FCV), and natural gas vehicles (NGV). In addition, fuel efficiency, semi and fully autonomous vehicles will surely reduce global oil demand.

The quantitative assessment carried out by Andreas and author looks at how much oil is expected to be displaced with the penetration of electric vehicles (EV) under alternative scenarios.  The authors concluded that under reference case penetration of 424 million EVs in 2040 is likely to displace 13.1 million barrels daily (mmbd) and under high cases the displacement of 38.9 mmbd in 2040.  

Electricity demand and renewable revolution

Thirdly, for global economic prosperity the demand for electricity will continue to increase as there is a strong positive correlation between electricity consumption and economic growth. However, it is important to know how it will be produced. Historically, coal has been the dominant source of electricity generation and in some countries its share was well over 60%. In 2012, coal accounted for 40.2%, natural gas 22.4%, hydro 16.5%, nuclear 10.8%, solar & wind 2.7% and others 7% in power generation. However, according to Bloomberg New Energy Finance (BNEF) study the way we get electricity is about to change dramatically, as the era of ever-expanding demand for fossil fuels comes to an end—in less than a decade.  

If the role of fossil fuels will be diminished in power generation then the question is, from where this replacement and additional electricity capacity would be produced to meet the ever growing electricity demand?  Surely, it has to be produced from renewables to protect global warming and save the humanity and the plant Earth.   

Technology – phenomenal renewable growth and dwindling cost

In 1995, there were only few countries in global wind energy group and by 2015 this group expanded to 105 countries. At the end of 2015 cumulative global wind power generation capacity increased to 432.42 gigawatts (GW), up from 4.8 GW in 1995 (Figure-1). The substantial growth in renewable is associated with improvement in technology and falling cost.  

Figure-1: Historical trend of global cumulative wind power capacity 

The cost of wind and solar power are falling too quickly and even current rock bottom coal and natural gas prices have failed to arrest the momentum of wind and solar energy growth (for example US Wind Energy Selling At Record Low Price of 2.5 Cents per kWh). In 2015 the global wind energy capacity increased by 63 GW as compared to 2014, which corresponds to about 60 nuclear reactors. This allowed wind power to surpass the dominance of nuclear energy 382.55 GW capacity in January 2016 (the London-based World Nuclear Association). Based on GWEC projections “wind power installations will nearly double in the next five years, led by China”.

The solar capacity increase to 230 GW in 2015 and within the next 4 years, BSW-Solar expects that the total global solar PV capacity will more than double, reaching to at least 400 GW. According to BNEF wind and solar will be the cheapest forms of producing electricity in most of the world by the 2030s.

Source: Solar Energy Industries Association

No matter what the magnitude of penetration of EVs, FCVs and autonomous vehicles, it will no doubt substantially reduce the global oil demand in road transportation in the coming decades. While significant increase in renewables in total energy mix will have a devastating effect on the role of coal and natural gas in power generation. For example, if the share of fossil fuel shrink from current 86% to say 45% in 2040 (oil and gas down from 57% to 30%), it will be big question for the survival of oil and gas companies. The expected level of investment during now and 2040,  in renewable $7.8 trillion (including $3.4 trillion for solar, $3.1 trillion for wind, and $911 billion for hydro power) while only $2.1 trillion is associated with fossil fuels is clearly demonstrating diminishing role of oil and gas companies. How much? Only time will tell.    

The future of oil & gas industry - Waking up in 2040

For the sake of discussions a senior oil and gas executive who had just formulated company’s new strategy, which is based on EIA-IEO-2016 wherein global oil demand is to increase from 90 million barrels daily (mmbd) in 2012 to 120.9 mmbd in 2040 and natural gas demand increases from 328 billion cubic feet daily (bcfd) in 2012 to 557 bcfd in 2040. What happens if he falls into a deep sleep and wakes up in 2040?

Based on current and expected penetration of EVs, FCVs, NGVs and renewables, it would not be surprising to see that world would have completely changed in 2040? Major chunk of ICs' fleet would have been replaced by EVs, FCV, NGVs and autonomous vehicles while households would have become self sufficient in generating their own energy needs. That is, most of the urban houses are covered with small units of solar panels to generate the required energy to meet electricity demand for their heating, cooling, lighting, cooking and charging EVs batteries etc.  While wind farm would be common in rural, remote mountains, offshore and isolated areas to generate enough electricity to meet the demand of the community.  No hassle, as everything would be under ones roof top or associated with community wind farms.

In such a scenario, what would be the reaction of this senior executive especially when the role of oil and gas has been substantially reduced (say from current 57% to 30%)?  In the light of current and expected changes in the global energy landscape, oil and gas companies need to correctly assess the reality of electric vehicles and renewables and change their strategies accordingly to avoid complete disintegration.