Crude Oil Prices: Lower For Even Longer

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By Greg Peel

On September 11, Goldman Sachs caused a stir on markets by suggesting the possibility the price of West Texas Intermediate crude could fall to as low as US$20/bbl, from a current range around the US$45 mark.

The WTI price did fall on the day Goldman's report hit the wires, but not markedly so. If anything, a level of mild amusement permeated the Nymex pits. In 2008, Goldman famously called the potential for WTI to hit US$200/bbl. At that point the price peaked, and began falling back from around US$157/bbl.

Did Goldman's latest report imply the bottom of the market had been reached?

That was the joke doing the rounds on the day. But to be fair to Goldman Sachs, the analysts were quick to point out US$20 was only a possibility, and not their "base case" expectation. Goldman's less sensational base case includes a forecast of US$45/bbl average in 2016, down from a previous US$57.

But the fact the leading US investment bank dropped its 2016 forecast that far is worthy of note, and on doing so Goldman is not alone. Over the past couple of weeks, a procession of brokers has dropped price forecasts by similar amounts.

From Australia's point of view, the Brent crude price is the more relevant indicator. With the Brent-WTI spread back to more historically familiar levels of US$2-3, we note Macquarie has dropped its 2016 Brent forecast to US$58/bbl from US$68, Deutsche Bank has cut by 20% to US$57, Credit Suisse has cut to US$58 from US$63, and UBS has cut to US$57.50 all the way from US$70. This still leaves Goldman's base case forecast as a low-end standout, if we add on US$3 for the sake of argument to the broker's 2016 forecast of US$45 for WTI.

There is little disagreement, nonetheless, as to why oil price forecasts have required downgrading.

Oversupply

Oil prices initially began to turn south mid-last year from just under the US$100/bbl mark. The rapid rise in US shale production had caught the market by surprise, given a lot of the supply increase was not just about new players entering a growing field, but due to a rapid improvement in the efficiency of shale oil extraction from back in the early noughties when horizontal drilling provided the industry breakthrough.

This meant lower costs per barrel. At the same time, geopolitical tensions that had kept oil prices above the US$100 mark had begun to subside, and the world started to worry about a Chinese economy that might be slowing a bit more significantly than previously forecast.

Oil prices finally gave way, and rapidly plunged to US$60/bbl. Never fear, said oil analysts, for every time oil prices fall below US$80, OPEC responds by cutting production quotas. OPEC has always been responsible in the past for the excess supply that has resulted in lower prices. This time the culprit was a new player – an out of control US shale industry. Thus it was that in December last year, OPEC declared it would not cut its quotas.

The WTI price promptly fell into the forties. Immediately, smaller late-comers to US shale were burning cash, and across the industry, marginal rigs began to be shut down. The WTI price appeared to bottom, and there was much relief when it returned to above US$60.

But the rebound had been all too swift, and more a result of speculative shorts in the futures market being rapidly covered. At US$60/bbl, much of the curtailed US production was simply switched on again as cash flow again turned positive. And the world started to become even more worried about China.  

Back we went. The WTI price has suffered from some extreme day to day volatility of late, but realistically it seems presently stuck in a range around US$45/bbl.

Chinese demand aside, there was still another issue on the supply side that analysts had not counted on. Once Saudi Arabia said OPEC would not cut production, all and sundry assumed the obligation lay with US shale, and fair enough. The market had not assumed US producers would take quite so long to reduce production, but the market never assumed that Saudi Arabia could effectively sound the death knell for the OPEC cartel and begin actually increasing production and dumping oil onto the market at whatever price it could get.

If US shale was not going to respond quickly enough, Saudi Arabia would damn well make sure it did.

On top of all of the above, the lifting of sanctions on Iran meant OPEC's once second largest producer of oil would soon return to the market, and like Saudi Arabia, pay no attention to the notion of OPEC quotas.

Lower For Longer

So while it is one thing for OPEC, or what used to be OPEC, to have not cut production, it is another thing for production to have been increased. And while US onshore oil rigs have indeed been steadily shut down, non-OEC production is nevertheless remaining more resilient than analysts had previously assumed.

The rapid improvement in shale oil extraction efficiency has meant the average breakeven price for marginal producers has also been falling as oil prices have fallen, delaying a necessary curtailment. Furthermore, access to cheap funding (Fed rate still at zero) has provided marginal oil companies with the capital capacity to hold on for a demand-side response.

While the anticipated boost to US consumer spending long anticipated from lower oil prices has been a long time coming, there is no doubt demand for automobiles and demand for gasoline/diesel, as was made clear in the US summer "driving season" just past, has notably increased. So too has fuel demand from China (and India) continued to grow at previously assumed pace despite a slowing in the overall economy.

Whether or not Chinese growth falls short of Beijing's 7% target in 2015, analysts still expect Chinese oil demand to continue to grow steadily. "While concerns over a possible slowing of global growth have risen," notes Deutsche Bank, "we can find no evidence yet of demand weakness in the physical market. We also expect China and India to contribute strongly again in 2016 despite slightly weaker Chinese GDP growth".

This has led to, as Goldman Sachs puts it, "deeply entrenched expectations that shale production growth will be required within the next couple of years". Throw in aforementioned access to cheap capital, and it is clear many a US shale producer is prepared to hold on and wait for demand to catch up with (reduced) supply.

The risk is that supply is reduced too gradually, Goldman suggests, and that's why the broker believes it is not beyond the realms for WTI to fall to US$20/bbl.

Beyond 2016

And all of the above is why brokers have one by one been slashing their oil price forecasts, particularly in the "near term" of 2016.

The International Energy Agency's August report suggested that the near term positive response in global oil demand arising from falling prices would appear to be insufficient to prevent global oversupply until late 2016. Oil analysts concur, hence brokers have been cutting their 2016 forecasts. And they also have lined up in agreement that the turning point will finally come around late 2016.

It will take this long, analysts suggest, for the supply-side curtailment previously assumed to have been well underway by now to finally make an impact. In short, US shale production will not be cut back until producers have suffered too long at low prices.

With regard aforementioned access to cheap capital, Citi notes the shale sector is now being financially stress-tested by low prices, exposing shale's "dirty little secret": many shale producers outspend cash flow and thus depend on capital market injections to fund ongoing activity.

Capital markets have thus far plugged shale's funding gap but are "showing signs of tightening," Citi suggests.

One issue is that some of the biggest lenders to smaller shale producers are smaller regional US banks. Not having the capital clout of the big boys, these smaller lenders sensibly approved loans to shale producers only on the basis that oil price exposure was hedged.

Hedges are typically put in place for one year. Oil prices began to tumble around June last year. The demise of marginal high-cost producers was thus delayed before hedges gradually rolled off. Over a year has now past, so presumably the last hedges are now gone. Banks are now rolling down the shutters of their lending windows.  Credit spreads on oil market loans are now rising steeply.

Bankruptcies are likely looming for weaker producers, Citi suggests. But "strikingly", Citi has found that the pace of aforementioned production cost reductions through efficiency gains can offset as much as a doubling in the cost of capital in just 6-12 months, indicating the sector's resilience.

Moreover, a steady decline in US storage costs has occurred over the past year or more. Ironically, storage, and the logistics of transporting oil, became a big issue when oil was up over US$100, which is why WTI traded at a discount to Brent of over US$20/bbl for quite some time. The industry has responded with pipeline reversals and other measures, and that discount gap has closed again, reflecting a fall in the cost of US storage/transportation.

The only way for US shale supply to be curtailed is for oil prices to remain lower for longer. The irony is (as is the typical case for any commodity), prices will only remain lower for longer if marginal producers hang on to the death and supply is not curtailed. Only when they can't hold on anymore, and finally pull the pin, can supply reduce and prices thus begin rising again.

Analysts agree this process will take until around late 2016. Thereafter, oil prices will begin to rise again on steadily rising demand, but given a return to around US$65/bbl would be enough for idled capacity to be switched back on again, a return to OPEC's once favoured US$85/bbl or the halcyon days of US$100/bbl of the past seems remote a possibility for some time, assuming no catastrophic development on the geopolitical front.

Oil-Indexed LNG Prices

Following a prior eight-year period of historically high oil prices, during which costs of LNG development escalated, the oil & gas industry is preparing for "normalised" prices, Goldman Sachs notes. Companies continue to cut budgets and become more efficient through redundancies, supplier renegotiation and deferral of investment projects.

The oil price shock became an Australian LNG producer share price shock. But Goldman Sachs has now upgraded its view on the energy sector to Neutral from Cautious.

Goldman is not alone in its thinking. Energy sector share prices have fallen a long way and in some cases into oversold territory, as far as brokers are concerned. Thus while Credit Suisse, for example, is among those assuming oil prices will remain at low levels until at least late 2016, the broker no longer has an Underperform rating on any energy stock under coverage.

Indeed, Credit Suisse's ratings are heavily weighted to Outperform, albeit the broker does not actually see outperformance ahead until the market is comfortable oil prices have finally troughed.

Among Australia's big LNG producers (or very soon to be producers), Oil Search ((OSH)) remains the favoured choice for most analysts. This was the case even before Woodside Petroleum ((WPL)) made a bid for the company, but now Oil Search effectively enjoys a floor price as well.

Brokers are split on whether Woodside will raise its bid to secure Oil Search or not, but either way Oil Search's 29%-owned PNG LNG is the most economically robust new project in the region, and Oil Search's growth options are among the lowest cost globally. The issue is whether these realities are already more than sufficiently priced in. The FNArena database shows five of eight brokers maintaining Buy or equivalent ratings.

Woodside is able to bid for Oil Search given a strong level of cash flow from existing LNG facilities (North West Shelf, Pluto) even at low oil prices. But a single-train Pluto marked the end of Woodside's immediate growth opportunities. The company's Browse Floating LNG development continues to progress, but completion may yet come down to just how long oil prices remain this low.

By contrast, Oil Search has PNG LNG, now underway and possibly set to grow to three trains. Origin Energy ((ORG)) has APLNG, which fired up this year, and Santos ((STO)) has GLNG, which will be firing up very shortly. Both projects should move into full production in 2016. Woodside's bid for Oil Search was clearly an attempt to plug the company's growth hole at a time low oil prices have provided an opportunity.

Woodside is otherwise supported by the company's 80% dividend payout ratio, which was maintained at the FY15 result. Such a payout of free cash flow is popular with investors, but investors still need to appreciate that "payout" means "of earnings", and as brokers have slashed their 2016 oil price forecasts they have also thus slashed earnings forecasts.

Woodside attracts only one Buy rating in the FNArena database.

Differentiating Woodside and Oil Search on the one hand, and Santos and Origin on the other, is that the former pair enjoy robust balance sheets underpinned by strong cash flows while the latter pair face serious debt issues – Origin more so than Santos.

Santos has drawn the most attention on this issue, with GLNG yet to start producing. Subsequently, Santos' share price has been the most hammered of the group. Indeed, too hammered, brokers believe, well into oversold territory, hence seven out of eight Buy ratings on the FNArena database.

Santos is presently undertaking a structural review, which will result in the sale of the company's non-core assets if buyers can be found. Failing that, Santos also has a minority (13.5%) stake in the PNG LNG "goldmine" Woodside is clearly keen to get a slice of. At the very least, Woodside's bid for Oil Search has brought the value of PNG LNG to the energy world's attention and hence an opportunity may present for Santos.

If all else fails, Santos may be forced to raise new equity, although with a GLNG cash flow boost just around the corner, it's touch and go, and may also depend on just how low oil prices stay for how long.

Origin has surprised brokers by seemingly being unconcerned about its debt level and as yet not suggesting any moves to do something about it. Origin attracts four Buys from seven in the FNArena database. Clearly the company is again beholden to lower for longer price concerns, but as the leading stakeholder in APLNG, Origin does have the opportunity to reduce its stake and repair its balance sheet.

The Australian Economy

It should be noted that as brokers have universally slashed oil price forecasts over the past few weeks, they have also made cuts to their Aussie dollar exchange rate assumptions. Reductions here have tempered, to some extent, flow-on cuts to earnings forecasts for the energy sector.

This brings into focus the impact of lower oil prices on the Australian economy in general.

If oil prices remain around current levels (Brent US$48, WTI US$45), the boost to global growth from lower energy costs should be around 0.5 of a percentage point, Commonwealth Bank economists calculate. The impact on global headline inflation should be a reduction of 0.5-1.5ppt in 2015-16.

Australia is a net energy exporter. Lower oil prices "may", says CBA, lead to lower LNG and coal prices. In the case of oil price-indexed LNG, one might assume it's a no-brainer. Coal prices are already depressed but are impacted by oil/gas prices on an electricity production substitution basis. CBA calculates a negative Australian terms of trade shock from lower oil prices of around 0.5ppt of GDP.

But an offset will come from the energy-consuming sectors in the Australian economy, the economists note, such as manufacturing, electricity production, and road, rail and air transport, which in turn lower costs for all sectors. The most positive boost will be felt in domestic household spending power, worth around 0.3% of household income, CBA suggests.

The same scenario holds for all average OECD economies, CBA notes, where most households and businesses are net energy consumers. Lower oil prices will boost discretionary incomes.

On a global basis, the economists point out, history suggest that during periods of declining oil prices, the rise in spending in oil importing countries exceeds the decline in spending in oil exporting countries.
 

* Swings to positive from negative, thus unable to be expressed as a percentage
 

 

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