The Outlook For Oil And Gas Prices

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By Greg Peel

Over a period of six years, the outlook for global energy supply has changed considerably. In 2008 the price of crude oil as measured by the then relevant benchmark West Texas Intermediate traded near US$150/bbl. On the assumption diminishing world oil production would meet rising emerging market demand, forecasts above US$200/bbl were being posted.

Enter North American shale oil. In 2013, the US imported an average of 7.8 million barrels of crude per day – nearly 25% below the peak in 2005 and the lowest level of imports since 1996. Not only have new technologies allowed for access to significant supplies of so-called “tight” oil, an impact has been felt on the demand side as well. Since the GFC, Americans have recorded fewer driving miles as households rein in their budgets. Coincident ongoing improvement in vehicle fuel efficiency has also contributed to lower demand, allowing US households to lower their consumption of gasoline and other fuels by 6.5% from the 2007 peak.

On the supply-side, US domestic crude oil production reached its highest level for 25 years in 2013. On current forecasts, 2014 will represent the first year in twenty the US will produce more oil than it imports. The US has reduced its nominal oil bill by around US$100bn since 2008 and on conservative assumptions (US$80/bbl long term oil price), Alliance Bernstein estimates US oil imports will drop by another US$100-150bn by 2020, lowering the import bill to 1% of GDP from 3.5% in 2008.

In the short term, the unwinding of the geopolitical premium placed on oil prices when Russia moved on Ukraine and the Islamist State moved on Iraq, along with the trimming of global economic growth forecasts and increased North American supply, have led to a sharp reduction in oil prices in recent months. After years of backwardation (spot prices exceeded carry-discounted forward prices), the Brent forward curve has now moved into contango (carry-discounted forward prices exceed spot prices).

It is the forward curve to which OPEC, and Saudi Arabia in particular, pays close attention when setting production quotas. When the forward curve moves into contango, OPEC responds with production cuts in order to support oil prices. But in the past, OPEC has had firm control over exports to the world’s greatest importer of oil, the US. Whatever production quota tactics the Saudis may choose to deploy in 2014, it will have little impact on preventing what Deutsche Bank believes will be a renewed rise in crude oil inventories at Cushing, Oklahoma, the pricing point for West Texas Intermediate.

“We view contango not only as a sign of an increasingly oversupplied crude oil market,” says Deutsche, “but that OPEC has lost control of the physical oil market”.

Over the past 20 years, OPEC has taken action thirteen times to defend the oil price, usually triggered by a shift in the oil forward to contango. It would be reasonable to assume the surge in North American crude oil supply growth would diminish the role of OPEC in manipulating the global oil market, but Deutsche believes the organisation, and the Saudis, will still have a significant role to play in the price setting of Brent. US producers are banned from exporting crude, hence OPEC can continue to control the market beyond the US.

It is difficult for Saudi Arabia to prevent falling oil prices through production cuts in times of global recession, as was the case the case in 2008, but in times of global growth such cuts have always proven successful. Given current forecasts suggest global growth of just over 3% this year, and closer to 4% next year, Deutsche Bank believes any attempt by OPEC to defend the oil price will be met with success once again.

Furthermore, while North American “tight” oil production has proven something of a revolution, the fact remains extraction is a high-cost business compared with conventional crude production. Consultant Wood Mackenzie estimates that around 30-35% of tight oil has a breakeven price of US$80-90/bbl. With West Texas now hovering just above US$90, any further price deterioration could trigger the first supply-side response in this revolutionary industry, in the form of production curtailments.

Thus between OPEC production cuts and possible US production curtailments, global oil prices will likely find a floor, Deutsche believes. On that basis, the broker sees recent oil price-related weakness in its preferred energy sector picks, Oil Search ((OSH)) and Santos ((STO)), as a buying opportunity. Woodside Petroleum ((WPL)) is more susceptible to oil price downside, but is supported by its sector-leading dividend yield.

The impact of falling oil prices flows through to global LNG pricing on a gas indexed pricing basis. The medium term outlook for international LNG prices remains clouded, suggest analysts at National Australia Bank. While demand in East Asia remains strong, forthcoming LNG export capacity in Australia and other areas combined with strong US shale gas supplies could place downward pressure on prices.

On the other hand, Australia’s gas producers are about to enjoy a step-up in prices achieved through gas sales to domestic wholesalers. The pending commissioning of Queensland LNG export terminals will see the Eastern Australian wholesale market exposed to “netback parity” pricing for the first time. Netback parity, also known as “export parity”, reflects prices determined by global demand and supply. To date only Western Australia has produced LNG for export.

The Western Australian government maintains a gas reservation policy which stipulates that 15% of gas production be made available for domestic use. The governments of the eastern states (and the Federal government) do not. There is no pipeline connection between Western Australian and the eastern states so there is no price levelling mechanism to create an “Australian” gas price. When Queensland shortly begins to export CSG-LNG to Asia, Australian domestic customers will have no choice but to pay the same price for their gas as China et al, net of transport costs.

While it is unclear exactly what impact the first eastern state LNG exports will have on domestic gas pricing, forecasts suggest prices will likely more than double. The impact will also flow through to gas-fired electricity production. Thus while the US economy is gradually enjoying a considerable boost from a step-up in domestic energy production, the complete opposite will be true for Australia.

The only real threats to newfound super-profits for the likes of Oil Search, Santos and Origin Energy is the restart of Japanese nuclear power plants and subsequent end to Japanese alternative gas imports, which is yet to happen and may occur over a prolonged period, and the ramp-up of a North American LNG export industry. Given, in the latter case, the US government maintains strict energy export controls, this threat is limited.

Australia is not the only LNG export aspirant but like Australia, global aspirants have found projects taking longer to sanction and construction taking longer to complete than previously assumed, and that multiple operational challenges are impacting on existing capacity, notes Credit Suisse. To that end the broker has now assumed incremental global supply growth will occur slower than prior forecasts suggest while demand expectations remain unchanged, leading the broker to push out its assumed point of global supply growth meeting demand growth to 2019 from a previous 2017 assumption.

The bottom line is unchanged: the best way to hedge against rising local energy costs in Australia is to invest in those companies enjoying the spoils on the other side of the equation.

Table 1 below provides forecast data for Australia's major listed energy companies. Table 2 outlines LNG project timetables.

Table 1.

Table 2.

 

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