The next year will be a momentous one for the oil and gas sector.
It is not only that the oil price crashed in the second half of this year and the stability of the previous five years has been lost, but that the crash led to a widespread conclusion by industry participants and analysts that the world oil market had reached a turning point, in which supply coming mainly from North America trumped any worries about disruptions in places such as Libya and Iraq, and that the market would be flooded for some time to come.
It is not just the supply-demand dynamics that will make next year significant. In the background for the entire energy complex will be the lead up to United Nations climate talks in Paris, culminating at the end of the year. Any policy that can be agreed to try to limit carbon emissions in the coming decades will have a profound effect on the energy complex in general, and on the oil and gas sector in particular.
As the International Energy Agency, the rich countries’ Paris-based energy think tank, put it in its annual energy outlook in November: “Policy choices and market developments that bring the share of fossil fuels in primary energy demand down to just under three-quarters in 2040 are not enough to stem the rise in energy-related carbon dioxide emissions, which grow by one-fifth.”
Even as market share for oil and gas shrinks, the overall increase in energy demand of 37 per cent between now and 2040 means there is still a hefty requirement for oil in coming decades. The IEA forecast world oil supply will rise to 104 million barrels per day in 2040 from last year's average of 90 million bpd, but adds that "achieving that level hinges critically on investments in the Middle East."
The critical question for the oil industry in the near term, then, is how the oil price drop – in which world benchmark North Sea Brent crude has tumbled from about US$115 a barrel in the middle of the year to about $60 a barrel by the end of the year – will affect investment in the industry, and in the Middle East in particular.
There are always a complex set of questions facing the oil and gas industries in a given year, but the recent price volatility makes next year more challenging that usual. One of they key questions that will determine how oil prices go is this:
What will be the near-term impact of lower oil prices on marginal production, especially the higher-cost oil coming from the United States and Canada?
Since the decision by Opec – a decision forced by its effective leader, Saudi Arabia, which is the only country with significant unused oil production capacity – late last month to leave its production target unchanged at 30m bpd, the focus of the oil market has been on what effect the oil price crash would have on US shale production.
It has become increasingly clear, however, that the economics of North American production are more complex than many had assumed. There had been a prevailing assumption that the “break-even price” for much of the US shale production was about $60 a barrel, but after the price crash it became clear that producers would keep on pumping up to much lower prices – maybe even at higher volumes – on investments already made as they try to maximise revenue.
The focus since has turned to how the oil price will affect future investment. As Amrita Sen, the head of research at London-based Energy Aspects, says: “[Capital expenditure] reductions have already begun – rig counts have started to come off, but the actual supply response may not arrive until the second half of next year. There are also downside risks to other non-Opec supplies, such as Russia, Brazil, North Sea and Mexico, potentially slowing non-Opec growth further from our currently expected 900,000 bpd.”
Chevron was the first major oil company to announce a cut in its expected capital spending next year, reducing it by 20 per cent. Most of the majors are expected to spend significantly less next year on marginal projects. But that is not likely to have any significant impact on the oil markets in the near term.
With lower oil prices, will demand rebound to soak up the excess production, which is estimated to be running at 1m bpd?
Francisco Blanch, the head of commodities research at Bank of America Merrill Lynch, expects that, as with supply, demand for oil takes time to respond to price changes. “Oil demand takes on average six months before it really starts respond to lower prices,” Mr Blanch says. “So the recent drop in prices could start to be felt in the second half of 2015, possibly at the same time that we see the first responses on the supply side. In our view, the lower prices go near-term, the greater the rebound we can expect in the second half next year.”
The rebound in oil prices will not be smooth, analysts reckon, particularly as Saudi Arabia has clearly decided to let prices find their own level so as to force higher-cost production off the market. This means instability will ensue. “Imagine the Fed effectively giving up on its mandate to keep US inflation in a steady band around 2% and arguing that consumer prices across the economy will ‘balance’ themselves overtime,” says Mr Blanch. “The consequences of this shift in Opec policy are profound and long-lasting … The first and most obvious consequence of giving up on price stability is, well, a huge pick up in oil-price volatility.”
So who wins and who loses in this likely see-saw ride for the oil markets next year?
There are more winners than losers in the world economy from lower oil prices, including big emerging-market economies such as China and India, as well as struggling advanced economies, especially Japan, which has no indigenous fossil fuel resources. Even the US, with its growing domestic oil and gas production, is still a large net importer of fossil fuels and estimates of the boost to the US economy have put it at around the equivalent of a fiscal boost of about $75 billion. The benefit to South Africa, for example, of a $10 a barrel fall in prices is estimated to be a boost of 0.6 per cent in its GDP.
The big oil producers in the Arabian Gulf are, of course, among the biggest losers, though not as badly affected as more financially vulnerable countries, especially Russia and Venezuela.
The damage to oil producers, however, is usually much greater than the benefit to consuming countries, and the wider risk of this is that the negative effects have a contagious effect that spreads through the world economy and outweighs the positive.
“The damage to net producers is typically 10 times larger than the boost to net consumers,” says Julian Jessop, the chief economist at Capital Economics. “This underlines the risk that the losers may be hit so hard that the fallout from their problems offsets the more diffuse benefits to the winners, even if the latter group is much larger.”
The risk of that may be limited, but it is still significant. Russia in particular has been a worry, as the memory of its late 1990s financial crisis and its effect on the world economy is still fresh.
amcauley@thenational.ae
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