What type of ride can the oil and gas industry expect over the next five years? Deloitte analysts forecast a U-shaped recovery predicting the average 2015 WTI price to reach $62/bbl and then to rise gradually over the next few years until it reaches a new steady range of $75-$80/bbl.
With the angst around the uncertainty of oil prices and its impact on industry outlook, Deloitte takes a deeper dive by examining some fundamental questions that frame the oil price market in its “Crisis Considerations and Implications for the Oil and Gas Industry.” Why did oil prices correct so suddenly? Is the current low price environment due to lower demand or increased supply or a combination of both? Also, when will the industry rebalance and recover? What will that recovery look like?
The correction is a net result of lower-than-projected demand growth and a remarkable increase in supply. On the demand side, in July 2014 the Energy Information Administration (EIA), International Energy Agency (IEA), and OPEC forecast 2015 global liquids growth to be 1.7% on average. However, these expectations declined to just 1.1% by December 2014, despite a low price environment that typically would have been conducive to boosting demand.
One reason for the muted demand response to the low price signal has been the increasing strength of the US dollar relative to other major world currencies. Notably, the US Dollar Index has risen nearly 15% to 97.4 since July 2014. A stronger dollar makes dollar-denominated crude more expensive for buyers using foreign currency. Consequently, while the United States is enjoying the full benefit of low prices, many other countries are only experiencing a portion of the price decline, giving them less reason to consume more petroleum products. On the supply side, several years of $100/bbl oil drove tremendous production growth in many countries. US crude output, including lease condensate production, increased by over 2 MMbbl/d from 2012 to 2014.
This domestic supply surge greatly offset US net crude oil imports, shrinking them from 8.5 MMbbl/d in 2012 to less than 7 MMbbl/d in 2014. Meanwhile, Brazil, Iraq, and Canada collectively added nearly 1 MMbbl/d over the same two-year period. All told in 2014, production growth of 1.9% exceeded demand growth of 1 percent, leading to an inventory build-up of 500 thousand bbl/d with another 400 thousand bbl/d projected for 2015. Is OPEC content to wait it out until high-cost producers fall by the wayside? Or, will OPEC cut production? When oil prices first started to fall, many thought OPEC members might agree to cut production to support prices.
However, members rejected that idea during their regularly scheduled meeting in November 2014, leaving OPEC’s official crude production target unchanged at 30 MMbbl/d. In light of the news, the market responded with an immediate 10% decline in the price of WTI crude.
OPEC-Protecting Market Share
Why couldn’t OPEC members agree on a strategic response despite the urgency of the situation? The opposing concerns of two different factions split the camp. The fiscal breakeven cost is the price that OPEC producers need to receive for their oil in order to balance their government budgets, which are heavily reliant on oil revenue. When prices fall below the fiscal breakeven cost, oil-exporting economies must make up for the shortfall by drawing on cash reserves or reducing expenditures. Countries such as Iran, Venezuela, and Nigeria have high social costs and low cash reserves. The collapse in oil prices not only puts them under financial pressure but also potentially threatens the stability of their governments if transfer payments cannot be made. These fears make them more amenable to crying “uncle” and cutting production to boost prices.
Meanwhile, other OPEC members, such as Saudi Arabia, Kuwait, and the U.A.E., have cash reserves to finance the shortfall for many months. Their biggest fear is not near-term financial collapse, but instead long-term loss of market share. Here, the strong oil prices over the last few years have worked against them in some ways. Prices in the neighborhood of $100/bbl have facilitated significant growth in global crude production, particularly in North America. Today, the increasing volume of unconventional production in the US and Canada is changing import/export dynamics and decreasing western reliance on OPEC producers. Rather than acting to defend prices, the Gulf producers within the organization, led by Saudi Arabia, are working to defend their global market share.
What is happening in China, the leading contributor to global growth? Is it rebalancing its economy or has it started a painful correction? In 2014, the Chinese economy officially grew at a rate of 7.4%, down from 7.7%, which represented the slowest rate of growth in 24 years. In 4Q 2014, the economy was up 7.3% from a year earlier, a figure that was a bit better than what investors had expected, but still indicative of a continuing slowdown. Moreover, the IMF now predicts that GDP growth will fall below the psychologically important 7.0 percent level in 2015. This raises questions about China’s future oil demand. In the past, China’s focus on infrastructure and capital projects made it the second largest consumer of crude oil in the world, and it imported large volumes of it at market prices—however high. But its transition to a more consumer-oriented economy might make it more price-sensitive in the future. Regardless, industry stakeholders should stay abreast of economic developments in China, since the nation has been responsible for 55% of total growth in oil consumption worldwide between 2005 and 2013.
How much new supply is poised to come online in 2015 and 2016? In 2014, new non-OPEC large-field projects (i.e., those producing over 25 thousand bbl/d each) collectively brought on 2.3 MMbbl/d in new supply. These efforts spanned diverse geographies and production methods, ranging from Brazil’s offshore projects in the Roncador, Parque, Iracema, and Sapinhoa fields to Mars B in the Gulf of Mexico, and to Russian and Canadian oil sands projects. Notably, these supply additions excluded the numerous shale oil fields being developed in the US. OPEC also contributed to the expanding large-field supply picture, adding another 1.4 MM bbl/d of new oil production capacity in 2014.
For 2015, a Deloitte MarketPoint analysis suggests large-field projects could bring on 1.835 MMbbl/d in new supply (i.e., 1.2 MMbbl/d from non-OPEC producers and 0.635 MMbbl/d from OPEC members). These projects are well underway and are unlikely to be halted, even in the current low-price environment. Taking this momentum into account, the analysis further forecasts large-field production additions of 2.676 – 3.434 MMbbl/d from non-OPEC producers and 0.759 MMbbl/d from OPEC members in 2016.
For the past two years, US tight oil production has grown at an annual rate of approximately 1 MMbbl/d. This growth is expected to continue in 2015, but at a slower rate.
While the recent drop in crude prices has squeezed the capex budgets of shale producers, some reportedly have been able to lower their operating costs to below $40/bbl through efficiency gains and better economics in the “sweet spots” of the shale plays. As a result, production growth is expected to continue in the short term despite low prices, albeit more slowly than in prior years. While there is no consensus on the extent to which growth will slow, many analysts expect declines of 300-500 thousand bbl/d off the 2014 pace. It is important to note that the world experiences a four to five percent production loss per year just from normal depletion. So the added production has to equal this amount if we are to stay even with no additional growth. Will the industry stabilize and balance after 2016?
Based on current data, demand should grow faster than supplies starting in 2016. Low prices over the next few years will likely inhibit investment in new projects—especially those in the early stages of discussion or in the engineering and design phases. It should also bolster demand, due to price elasticity, much faster than otherwise would be the case.
What does the future look like in 2020? The Deloitte MarketPoint World Oil Model (the Model) provides some insight into where prices might be headed. The findings from the Model’s output include the following:
· Based on the EIA’s estimates, production is expected to continue to outpace demand in 2015 by approximately 400 thousand/bbd. This assumption is driven largely by continued production growth through the first half of 2015 as many producers strive to complete projects falling into the “too late to turn back” category and as yet-to-expire hedging contracts allow them to continue producing despite uneconomic market conditions.
· On a half-cycle basis, oil prices could fall below $40 bbl. There have been several periods in the last 25 years where prices have dipped well below this level. However, in the current market environment, some of the very low prices witnessed in the past are unlikely to reappear, at least on a sustained basis. Since oil markets are self-correcting, market forces should trigger an adjustment, mainly through low prices that engender more demand, decrease marginal, high-cost supply, and encourage supply depletion. This suggests that historically low prices could not be sustained for more than 3 to 12 months, absent other drivers affecting demand.
· If the low-price environment continues as expected through the first half of 2015, it should trigger a demand response that will likely be felt in the second half of the year. This is the same time period when cut-backs on the number of shale drilling rigs in operation, expiring hedging contracts, and other production-related belt-tightening should start to have a more prominent effect on production growth and market perception.
· As a result, Deloitte forecasts crude prices to rise in the second half of 2015, elevating the average annual price above present levels. Additionally, the forecast expects the average 2015 WTI price to reach $62/bbl and then to rise gradually over the next few years until it reaches a new steady range of $75-$80/bbl (i.e., combined WTI and Brent world crude price) as early as 2018. With only negligible shifts in demand or production in the next 12 to 18 months, the average price could likely be lower, and the recovery would likely be “U” shaped, reinforcing the price signal to shale producers to decrease production. Forces that could potentially make upside price scenarios more likely include any number of black swan events affecting supply or the perception of supply scarcity. However, since oil markets are highly cyclical, they tend to overshoot or undershoot most long-term outlooks.
So what do companies do in the meantime? Enlightened companies will use this time as an opportunity to improve their organizations by continuing to focus on operational efficiencies, reduced and/or refocused capital expenditures, portfolio upgrades and talent acquisition. On the talent acquisition side, it is a good time to focus on hard-to-fill positions with more candidates in the talent pool due to layoffs.