Joseph Mariathasan considers the likely trajectories of oil prices
The news oil has almost touched $50 (€44) a barrel may bring cheer to some, but few would claim it represents a turnaround for an industry that still faces considerable challenges. Assessing the shorter-term prospects for the oil and gas industry as investments is highly dependent on forecasting oil prices, and that – as even the oil majors such as Shell have found – is not so easy.
There have certainly been instances over the past few decades where dramatic price falls – to as low as $10 a barrel – have caught the industry by surprise. Indeed, the drop from well over $100 in 2014 to less than $40 at the start of this year was also an unexpectedly severe drop that has left the industry floundering. Yet the short-term volatility may be hiding a longer-term reality. It is worth recalling the oft-quoted comment by sheikh Ahmed Zaki Yamani, the former Saudi oil minister: “The Stone Age did not end for lack of stone, and the Oil Age will end long before the world runs out of oil.” The increasing pressure to alleviate global warming makes his prophesy look even more pertinent.
Longer term, if the issue of unacceptable man-made global warming is to be resolved, there may be no alternative to increasing the use of alternative energy sources, including nuclear power. Shorter term, however, there is still debate over the likely trajectories of the oil price.
One argument is that the laws of supply and demand should bring things into balance in 2016. With US exploration and production capital-expenditure budgets slashed for this year and the rig count continuing to fall, the oil bulls argue there should be meaningful production declines from the US shale basins. That should contribute to non-OPEC supply contracting by more than 600,000 barrels a day, or around 0.7% of global supply.
Outside the US, it is difficult to see from where the supply growth could come, with Saudi and Russian volumes close to capacity. Others argue the sheer size of available fracking reserves will always put a ceiling on prices, even if investment in conventional long-tail projects is reduced. Fracking can be brought back on stream very quickly. Companies are slashing costs and finding new ways to complete wells in the shale. While drill counts may have dropped in response to the price collapse, price increases will start bringing rigs back on stream as operators hit their break-even levels. That is likely to put a ceiling on oil-price increases.
Fracking has been a game-changer for the economics and politics of oil. For the US, the attainment of self-sufficiency in oil over a long time period would have immense ramifications on its foreign policy towards the Middle East.
A big loser would be Saudi Arabia, whose leadership has used the support of the Wahhabi clergy for legitimacy and the wealth it accrued to export this brand of Islam globally. While US support is clearly still strong, the underlying tensions are obvious. The Saudi Arabian leadership needs US support, but they face a delicate balancing act as they struggle with the tensions inherent in their society. Ensuring support means ultimately ensuring US reliance on Saudi oil, and, to ensure that, it needs to drive the fracking community out of business.
That has another side benefit where Saudi Arabian interests coincide with those of the US. Russia depends heavily on energy exports, which may account for as much as 70% of total exports. It was the low oil prices in 1990 that contributed immensely to president Mikhail Gorbachev’s struggle to keep the USSR solvent and helped lead to its eventual collapse in December 1991.
Perhaps, as some argue, the transition to alternative energy sources is an opportunity, as long-term demand displacement from alternative fuels and renewables curtails exploration and long-tail projects in oil and gas, impacting supply and giving oil the potential for a strong bull market in the medium term as long-term investment is reduced.
But few would expect prices to reach anywhere near $100 a barrel for many years to come, if ever, given the pressures to reduce fossil fuel consumption. Investors should consider that perhaps high-yield debt may provide a better risk/reward play than equities for the oil and gas sector. If oil prices are $40 a barrel or less in a year’s time, a lot of producers will default. Those producers that can still find equity will increase their share, and low-cost producers will fill the gap.
The oil majors with high costs of production and few attractive development opportunities may find acquisitions attractive and start taking over some exploration and production companies. The high-yield bonds issued by those companies would become investment grade, and investors would see huge returns.
Joseph Mariathasan is a contributing editor at IPE