The Oil Price decline since July 2014 with brief stopovers at $80's and $60's kept the analysts and economists guessing and hoping for a rebound but the price war and market share retention strategy kept the pressure on oil prices throughout the period of decline with 'brief' V curves during the 'journey downwards' and for the first time making the geo political factors relatively 'irrelevant' in the oil pricing game. Here we find in January 2016 a further sliding down and crossing the important barrier of $30 a barrel. This all was largely unpredictable few years ago when the price a crude oil was rising and crossed the $114 barrel mark. Since then the reality is that price of oil has indeed plunged by over 70% in a little over eighteen months.
The 'Opec' decision to protect its market share VS the 'Oil Price' and 'Shale Drillers' continued resilience and Non Opec countries economic compulsions helped the Oil Price spiral downwards due to supply glut with demand reducing due to China growth factor and similar concerns for Europe and some other countries not doing too well in future growth terms. Opec members having chosen to let the market play out for the time being continues till to-day. Opec decision to defend the 'Market Share' and NOT the Price is a strategy that is being applied at present.. The Brent crude oil benchmark having touched the lows of $29 (Now recovered to $32) from the highs of $114 a Barrel in July 2014. It is expected that the price fluctuation will continue with downward pressure on oil prices for some times to come and a lot would depend on what policy decisions are taken by the major oil producers ie Opec countries, Russia and USA as well as how market reacts to the uncertainties stemming out from Iran, Iraq, Syria and Libya in a political cum economic context.
With higher supply of crude Oil and petroleum products availability due to higher refining capacity world-wide and lesser demand, the buyers will shop around for lower prices. Different suppliers have different financing models and so those with loans to pay back soon will panic and drop their prices drastically to make sure they sell all of their stock quickly. Sooner or later, they have to decide to stop increasing their inventory of unsold product, and eventually shut down production. Liquidity and Financial challenges therefore will start kicking in as a result with obvious consequences.
Normally market involves many different producers in many parts of the world. Each has different priorities and strategies. Generally, economic theory applies and the weakest go out of business, or mothball their operations, while the strongest sail through the crisis with only reduced profit margins to show any damage of the period of oversupply. In the oil business, the strongest players are the Gulf States and the strongest of all is Saudi Arabia.
The USA, Russia and Saudi Arabia each have different reasons to continue high output, but all three are just stockpiling oil because they cannot find enough immediate buyers. Add on the inevitable return of Iran and possibly Libya and the prospects of the 2 to 3 million bpd already excess production in the world reducing can be seen to be quite difficult. The current storage of Inventories world-wide now touches Three Billion Barrels of Crude Oil which is roughly equivalent to one month of global demand.
The reality is that the world economic growth did not materialise in 2014 or 2015 as was being predicted. That shortfall caught most of the economic and energy experts including the big banks and oil industry analysts by a bit of surprise and a bit due to forecasting failure as the big picture of emerging world realities got largely ignored due to 'no precedence' and was consequently not in the ' business models' that were being used for projections . Apparently the US government did not produce the oil price fall, it may have been just as surprised by it as industry analysts, academics and economic/energy advisors across the globe. Market analysis shows that the new price levels of oil are caused by the simple mechanism of supply and demand. Globally, the 2014 and 2015 slower economic growth in Europe and China took capacity planners and market makers by surprise; the developed world's drive to decrease carbon emissions is finally having an impact on the oil market through greater energy efficiency. Therefore demand for oil declined unexpectedly in 2014 and 2015 creating the supply glut that was not envisioned and consequently the price spiral downwards.
Reasons:
In view of the preamble stated above the world's largest producers of oil - the USA, Russia and Saudi Arabia each had financial needs that prevented them from reducing production. Politics and Geo Strategic interests may also have played a part in the decisions NOT to cut the production to match a fall in demand and thus the market became over supplied, causing a fall in prices. Non-conventional Producers (principally shale drillers) of Oil who faced a battle of survival also added to the supply glut. The following major reasons can be further explained below:
1. Declining Demand
Due to slow down of the economies of China and some western countries, the excess supply in the oil market could not be absorbed or demand increased significantly. Also there is no great leap in growth expected in the rest of the world for the next couple of years as is being projected now. Energy efficiency and investment in renewable energy, such as solar and wind in Europe and elsewhere, has permanently reduced demand for oil in most of the developed world as well as emerging economies.
The BRIC (Brazil, Russia, India and China) economies have also failed to continue their growth into 2015 and their 'GDP Growth Rates' have also declined except India. Brazil is now in recession, with tumbling currencies cutting their populations' spending power. Russia is not doing too well due to its principal export 'Oil & Gas" having reduced in value and quantum, India has just maintained its growth pattern and China's double digit growth has been reduced to 6.9% which is lowest in many years. As World trade is falling the demand for oil is falling too. With few prospects of increased demand for oil, the supply glut continuing due to unconventional sources emerging with all the technological innovations the chance of oil price rising to peak levels achieved in 2014 and earlier are almost NIL.
2. OPEC Inaction
Previous oil price falls have been keenly countered by Opec, the cartel of oil producing nations, centered mainly on Middle Eastern producers. Whenever oil prices fall, Opec cuts quotas to its members, limiting their production and causing the price to rise through reduced output. Now there are disagreements with Opec countries on the strategy of protecting market share VS the Price of Oil. Various meetings have yielded no results. Each meeting failure has resulted in further oil price reduction. It is generally thought that the strategy of protecting market share at the cost of 'declining prices' is a smart and well thought out strategy of Opec countries. This strategy will drive out non- conventional producers principally the 'Shale Oil & Gas "producers around the World and in particular the ones located in United States. It will also reduce the initiatives on 'Renewable Energy' and in the short to medium term (2016 to 2020) eliminate or significantly reduce the competition and threat of 'Alternative Energy'. The fittest and most economical energy segment producers around the world will survive and the rest will be phased out as the existing 'Technological' innovations will be further enhanced to gain competitive advantage and new horizons will be aggressively pursued by the non- conventional players.
3. Fracking Technology for Shale Remains
The 'Hydro Fracking' technology provided the USA with a means of achieving energy independence. The country has already become a net exporter of gas, and similar performance in oil production after the lifting of the 'export 'ban after 40 years is expected. This initiative would remove USA's dependence on imports and make it a Net Exporter of Oil in the days to come as long as excess production capacity driven by shale production is maintained. However the phasing out of Shale Oil & Gas Producers will create challenges for achieving this objective in the years to come.
The rig count in the USA reduced from 1,608 in October 2014 to 747 in April 2015 and has stayed around this level through 2015. Seemingly, the lower oil price had squeezed out US oil production in the higher- cost fracking sector. However, the advancement of technology and the agility of fracking producers resulted in higher output from fewer rigs. The 2nd largest economy 'China' has also become a player in 'oil production through fracking technology' and has raised its production. The world has excess production of 2 to 3 million barrels per day. America's increased production means that oil prices are not about to rise. China's initiatives in Shale and Gas production will also keep their imports down.
4. Iranian Oil & Gas Returns
Sanctions against Iran have existed in various forms since the eighties. However, sanctions ramped up to the point of shutting Iran out of the oil markets in January 2012, when the US insisted that Iran cancel its program of tests of nuclear weapons. Iran is still able to produce 2.7 million barrels per day, of which 1 million is exported. The un-exported 1.7 million barrels meet domestic demand, but a large proportion is sent to storage. The world currently has excess crude oil production so a cash-strapped Iran could have impact on crude oil prices by putting millions of barrels of stored oil on the market the day sanctions are fully lifted. The market has currently priced in the 'Lifting' of Sanctions on Iran but the excess supplies will continue to put downward pressure on Crude Oil prices, notwithstanding the recent Saudi- Iran political crisis which if escalated may reverse the downward trend.
4. Russia Produces More
The Russian economy is overwhelmingly dependent on oil and gas exports, because it has little successful industry and is unable to match the West in the development of technology. Russia needs money to continue its glorious and domestically popular policy of re-emerging as super power. The Russians refuse to bend to market forces and so have made up the shortfall in their budget caused by falling oil prices by pumping out more oil. Increased production adds to the downward pressure on crude oil prices.
Challenges
The price of oil has been falling since July of 2014, and many industry analysts are trying to find a direction in the market. Many are of the opinion that the price of oil will rise again and seek any signs of their hoped-for increase; others can see no reason for a rise and explain that the low price of oil is now the new phenomenon.
US fracked wells are deemed to be among the most vulnerable producers to be squeezed out of the market due to high exploration and development cost of fracking whereas the Gulf Producers are the lowest cost producers and will retain a distinct advantage of their competition.
It is good to believe that Shale Fracking in US and elsewhere would survive and would in the end play 'Balancing Role' and strike equilibrium in the world oil prices at least to the point of their " Break Even" levels. The developed countries that thrive on innovations and technology improvements are not going to sit idle and their ingenuity is at work with missionary zeal and will find new ways to extract oil profitably at lower prices. The enterprising spirit of frackers around the world explains why they were not closed down by lower prices and actually managed to extract more oil profitably at the levels lower than $60, which is on average their breakeven point. However they are unlikely to survive for long if the Price of Oil remains below $40 for long time and their respective Cash Breakeven points will make a serious dent to their survivability. Shut down means: No cash Flows, No repayments of their Loans, No Cash Available to pay for their Operation and Maintenance Costs and therefore the financial institutions that initially funded them with say 60% to 80% of the project costs will not get their interest or principal repayments and hence the 'Bankruptcy' of many high cost producers will be a reality soon.
Forecasting Failure
Forecasting 'Oil & Gas' prices accurately whether short or long term is a nightmare even if all assumptions and factors have been taken into account. Uncertain factors like Geo Politics, Geo Economics, Changing Policies of different countries makes the ' Oil, Economy and Politics' members of the same 'un predictable family' that is deeply inter woven with each other and can hardly be separated. The failure of oil industry economists to predict the price of oil was simply because most future predictions are based on examining what happened in the past. Everyone expected the Opec to cut production and maintain prices as they did in the past. This did not happen and the supply glut started to accumulate filling in storages both onshore as well as offshore on Oil Tankers and with falling demand . The 'Upstream' sector therefore started getting into 'slow down' production mode or shut off of certain wells. This impacted new projects on the drawing board and eventually the fallout resulted in massive layoffs in the oil industry. The livelihoods of Energy Sector employees were impacted and over 100,000 jobs have either been lost or are expected to be lost. Around 200 major Oil & Gas Projects valued at approximately $200 Billion have been shelved or delayed.
The oil price fell from $114 per barrel in July 2014 to around $29 at the beginning of 2016. Since then it has recovered a bit to $32 for the Brent Crude and by a new phenomenon the WTI (West Texas Indicator) is also the closest to Brent crude Oil Price. Some analysts predicted that the price would continue to fall to a new low $20 or even lower. Very few see a rebound on the horizon and others felt prices would stay the same for years to come. One thing analysts unanimously agreed upon was that US fracking industry has faced an immense set back in recent times.
The average fracking well had a breakeven point at an oil price of $60 per barrel, meaning when the oil price dips below $60 the average fracked well is no longer profitable. American frackers were being squeezed out of the oil market. This is being seen as a failing industry, financiers are unlikely to back shale oil developments again due to the volatility and unpredictability of Oil Prices.
Opportunities
-- Windfall for Oil Importing Countries
The shift of wealth from Oil Producing countries to Oil consuming countries provide the later with immense benefits of lower oil prices thereby reducing their import bills by billions of dollars and reaping other benefits of lower energy cost that builds into the cost of production, value additions and helps changing individual consumption patterns. The savings in energy cost will enable developing countries as well as the developed world to divert its resources to socio civic activities, health and education etc.
-- Ingenuity Kicks In
Oil industry insiders who predicted the death of shale oil in the United States got it wrong. They overlooked the fact that fracking is an innovative technology and the entrepreneurs that mastered it are quick thinkers and eager capitalists. The fall in rig count does not signify a dying industry. In fact, the start-up costs of a fracking well are the major contributors to that $60 per barrel breakeven point. By extending the life of wells, shale oil producers have slashed their costs.
US oil production has so far not reduced much in the face of falling oil prices. Shale oil producers are getting more oil out of fewer wells and that factor is keeping the industry alive. They will be forced to think out of the box and go for innovative solutions. Therefore the ingenuity will be at work full time 24x7 which ultimately creates economic benefits for the stakeholders.
-- Advancement of Technology
The technology surrounding non-conventional oil extraction has continued to be refined and the costs of drilling and processing equipment have fallen steadily. The oil price crash will rapidly accelerate the advancement of technology that was already underway. Automation and technological improvements will be game changer for the future.
Cost-saving technologies include more efficient exploration methods, onsite automation systems and intelligent production monitoring software. Beyond cheaper hardware the next saving opportunity lies in advances including more automation: intelligent control systems requiring less physical workforce, less downtime and improving yields of existing wells.
Current & Future Scenario
"ENERGY LANDSCAPE HAS CHANGED FOR GOOD" - Oil producing countries have realised this new phenomenon and have taken or are taking the steps accordingly to address these realities. Major Examples are 1. USA Lifting its 40 years Old ban on its crude oil exports 2. Opec countries and in particular Saudi Arabia imposing Fiscal measures in the form of budget cuts, imposition of taxes and withdrawal of subsidies etc. 3. Oil Producing countries diversifying and investing into downstream and value added industries. 4. For the first time Saudi Arabia has considered that ARAMCO or its Subsidiaries may be offered for Initial Public Offering at a time that the 'Valuations' of energy sector entities world-wide are lower than any time in the last couple of years.
The continuous fall in the price of oil has the potential to trigger a gradual slowdown of major economic powers of the world like USA and Russia and to a limited extent China. This phenomenon is also impacting the BRICS economies, Latin American economies and indeed the Gulf countries of the Middle East. The global meltdown is triggering a collapse in the stock markets around the world which have become very volatile recently. The financial devices and their valuations used to fund oil exploration and production throughout the world have been negatively impacted. Modern oil exploration is financed through a range of methods including issuance of shares to increase capital, and raising debt through bonds and bank loans. This financial chain is disturbed in a big way. A shale oil well operating through hydraulic fracturing with oil price hovering close to $100 per barrel, banks were more than willing to finance billions of dollars' worth of oil exploration projects then it is now with oil hovering around $30 or $40. Accordingly a credit-worthy healthy company moves towards bankruptcy as a result of a price going below their breakeven points.
In addition to those companies that are directly engaged in Oil exploration and production as well as large financial institutions that finance them, there is a large industrial sector supplying tools, chemicals and equipment to the oil industry and the value of shares in those companies will decline as oil production winds down.
A sudden shortfall of cash caused by an unexpected fall in the oil price could then trigger a sell off on major stock exchanges prompting the price of most of the shares to drop under an urgent rush to sell by the weary and jittery investors who may be institutional investors or private investors who are sitting down on the sidelines waiting for the downturn to reverse.
-- Impact on GCC Countries & Pakistan
The shifting of wealth in the wake of reduction of annual revenues of GCC countries due to mainly oil prices reduction by 70% and revenues reduction by about $500 billion a year collectively will have negative repercussions on the economies of those countries resulting into extraordinary fiscal measures and a visible change in how the countries of the gulf conduct their business going forward where millions of Pakistanis work and send their remittances back to Pakistan making 'Foreign Remittances' largest part of our 'Foreign Exchange' reserves. The GCC countries will be directly impacted by this downturn as their ' Future Wealth Accumulation' will reduce and their ' Past Accumulated Wealth' will be needed to fund their existing infrastructure and the fiscal deficits. This new phenomenon will be reflected in their individual as well as state level spending patterns,. On the individual level the GCC citizens will likely refrain from their extravagant spending habits as well as becoming more risk averse in their investment decisions which are mostly located abroad in western countries mainly in real estate or shares as well as larger stakes in companies which may also be impacted by the downturn with lower revenues and lower valuations.. Likewise the Governments level strategic and long term investments overseas will also be subject to the new valuations. Also some of them will be liquidated to fund their budgets adding selling pressures on both real estate and investment /banking sector globally. Also the GCC Governments are also likely to cut on their Capital Spending on some of their projects that will lead to lesser job creations and hence a snow balling impact on the economies of all the countries in the region.
Pakistan too would need to readjust its expectations in terms of the new emerging realities and adapt itself accordingly. The lower import bills on Oil and Petroleum products in the next few years and beyond is a very welcome development and this windfall has created a space to address our financial as well as energy sector issues in a comprehensive manner going forward.
In conclusion:
1. The volatility in oil prices and consequently uncertainty in the world of Energy, Politics and Economics will continue to prevail due to an unavoidable relationship between the three elements.
2. Politics and the tussle between the sole super power and countries that continue to challenge that status quo of the sole supremacy will determine the future of oil crisis that currently exists.
3. Therefore it is not a game of pure supply and demand. It is also a game of reigning supremely : politically , economically and militarily that will determine the future of energy, it's availability as well as its price.
4. Meanwhile the countries that can benefit themselves because of lower oil prices should take maximum advantage of this windfall in order to address the complexities previously caused due to very high and abnormal energy price of the past.
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