Lower for Longer

It’s the default phrase for discussing the future direction of energy prices. But will it really prove to be the case?

“I do think the industry needs to prepare for lower for longer.” Thus spoke BP Group CEO Robert Dudley when he was interviewed by a CNBC anchor on the sidelines of this year’s IHS CERAWeek energy conference in late April. While the phrase, “lower for longer,” has since been adopted by many energy company executives and Wall Street investment pros, Dudley used it to highlight the impact of sustained low oil prices on BP’s fourth quarter and full-year 2014 earnings, released in February 2015, barely 60 days after the fateful November decision by Saudi Arabia to let market forces determine the value of crude oil.

After just two months, collapsing oil prices had shaken the industry’s belief that years of high oil prices had established a new pricing norm for the business.

“Resetting” the Cost – and Price – Base

We doubt Dudley expected his view of the industry’s outlook would become the default phrase among his peers as they attempted to explain why they were cutting their capital spending and dividends and laying off staff less than 12 months after those same people were being offered signing bonuses and high salaries. 

In his February 2015 comments, Dudley stated, “Given the uncertainty of the outlook, we now also see it as prudent to reset our cost base for a more sustained period of lower oil prices.” He went on to outline a number of steps BP would take to better position itself for this new environment. So far Dudley’s view of the future looks prescient as Brent crude prices were in the upper $50s per barrel at the time he spoke but now sit in the mid-$40s. Even though North American and international oilfield activity has fallen during 2015, global supply still outstrips demand. Burgeoning inventories around the world are depressing oil prices.

As oil company managements confront a future marked by little hope of meaningful improvement in oil prices, they are now “resetting their cost base,” which signals employee layoffs along with another year of lower capital spending. Recently, Dudley outlined what “lower for longer” means for his company: restructuring assets and employees until the company can support operations and pay its dividend even if oil prices never rise above $60 a barrel. 

A Canadian energy research firm uncovered the fact that reduced capital spending for both 2015 and 2016 will mark only the third time since 1950 that there have been back-to-back years of capital spending declines in Canada’s oil patch. The U.S. has had a different experience.  Since 1972 there have been only two episodes of consecutive years of oil industry capital spending cuts, but they have been lengthy. The first was a five-year stretch of declining annual spending from 1982-1987. That included 1986, the year the war among OPEC producers peaked when Saudi Arabia gave up defending the organization’s oil price by lowering its own price to regain lost market share. 

The second time capital spending fell consecutively was from 1997-1999, which coincided with the Asian currency crisis that exploded on the global stage shortly after OPEC had responded to accelerating economic growth in Southeast Asian countries by stepping up its output to supply them. When the crisis emerged, a global recession developed that cut oil use, producing a rapid increase in oil inventories and driving prices sharply lower.

Another cut in capital spending by the U.S. oil industry in 2016 will mark only the third time in modern history that there have been back-to-back reductions. The concern of oil service company executives is that 2016 might not be the last year of reductions. 

Bulls & Bears

Understanding what the global oil industry may encounter in 2017 and beyond is the starting point for separating oil price bulls from the bears. That separation is more dramatic in the near-term but more nuanced longer-term. Trying to discern where the bulls and bears land in their outlooks is challenging. 

If we examine the most recent forecasts for the over- or under-supply in global oil markets heading into 2017, we find a wide divergence in what the experts expect. The most bullish view is held by the International Energy Agency, which sees the world oversupplied by a net 250,000 barrels a day (B/D) in the fourth quarter of 2015 but undersupplied by the fourth quarter of 2016 by 1.1 million B/D.

At the other end of the spectrum is the U.S. Energy Information Administration. In its most recent “Short-Term Energy Outlook,” it sees the world market oversupplied by about 1.5 million B/D in the fourth quarter of 2015 and oversupplied by 1.7 million B/D in the fourth quarter of 2016. Interestingly, the EIA sees the current oversupply shrinking to about 700,000 B/D by the first quarter of 2016 before rebounding to the 1.7 million B/D oversupplied status by the end of 2016. 

One shouldn’t be surprised to find that OPEC stands between the other two forecasters. It sees the current oversupply margin shrinking to only 500,000 B/D by the fourth quarter of 2015 and then declining further to a 200,000 B/D surplus at the end of 2016.

Supply & Demand

So if the most experienced oil market forecasters can’t agree on how much the market will be oversupplied in the future, what’s a poor energy executive to do? Instead of looking at the final supply/demand numbers, he should examine the forces shaping the forecasts. In reality, that means understanding what makes supply go up and down as well as what moves oil demand. 

We have already seen low prices impact U.S. shale oil output as supply has fallen by about 450,000 B/D currently and there are forecasts suggesting it will fall by nearly 900,000 B/D by the middle of next year. At that point, U.S. oil output will start climbing as a handful of new Gulf of Mexico fields are scheduled to begin producing with volumes greater than the shale oil reduction. 

Another challenge on the supply side is predicting when, and by how much, Iranian oil will return to the market following the U.N. nuclear weapons deal and the termination of economic sanctions against the country. Estimates range from 500,000 B/D to as much as one million B/D. There are other variables as well that will affect future supply such as the volume of output from producing countries impacted by terrorism as well as from countries pumping up output to bolster their revenues. 

Oil supply growth has been helped by the availability of cheap capital – equity, bank debt and high yield bonds – as well as by a flood of private equity seeking to back new management teams in building exploration and development companies to exploit global shale and offshore basins. This capital flow is not likely to end until either oil prices fall to lower levels and/or investors elect to write off the industry as a potentially attractive investment sector. 

On the demand side of the equation and despite warnings about slowing global economic growth, consumption in developed economies is growing in response to reduced oil, gasoline and diesel prices. These lower prices have contributed to oil’s displacing coal in certain energy markets.  The concern, however, is that the world’s economies are trapped in a low-growth environment as a result of government policies enacted following the 2008 financial crisis in order to prevent such an event from recurring.

Many important energy-consuming markets are also facing demographic challenges that work against high rates of economic growth and energy consumption. Other considerations, such as the strength of the U.S. dollar versus other currencies and the push for more and greater mandates for renewable fuels, will also impact oil’s use over the next year and longer-term, too. 

Near-Term Pain = Long-Term Gain

In our view, conditions are ripe for 2015’s lower oil prices to stimulate greater consumption globally at the same time that spending on drilling and production is being cut back. Energy consultant IHS has reported that over $200 billion in new oil projects – both short-term and long-term – have been delayed or cancelled, which will surely impact future oil supply. 

While it may take a while for swollen inventories to shrink, it is likely prices will begin rising during the second half of 2016 in response to the need for more oil by 2020. What will then become the industry’s focus is how high oil prices will rise. The greatest disappointment for oilmen may be that $100-a-barrel oil won’t likely be seen again in this decade.

The oil industry’s challenge will be if prices settle in a $58 - $65 a barrel range for the foreseeable future. While that will boost the near-term outlook, it does not relieve managements from having to continue to lower their cost structures. Unfortunately, some near-term pain is necessary to improve the industry’s longer-term outlook. – MarEx