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Oil in 2015: Who will blink first: the sovereigns or U.S. drillers?

This article first appeared on the Energy and Carbon Blog at:http://energyandcarbon.com/oil-2015-will-blink-first-sovereigns-us-drillers/

The recent fall in oil price is all to do with excess supply. How drastic the fall has been is largely down to the widely held view that OPEC and particularly Saudi Arabia would take the necessary steps and cut production to keep the oil price up. The Saudis had already signaled the market back in September that they were unwilling to play the role of central banker for the oil world anymore and come the OPEC meeting at the end of November oil prices were already down 30% from June. However, OPEC ministers left Vienna with no agreement on production targets. Since then oil prices have fallen by just under 30% from $74 a barrel to close 2014 at a 5 year low of $52.72, and that in four weeks, and the next OPEC meeting is not scheduled to take place till 5 June 2015!

The new reality for the global oil market is 1% growth in demand per year and negative to flat growth in the OECD as opposed to the 2.3% average annual growth in demand the oil industry has experienced for the past 60 years (see graph below). The reason is technology improvements which have pushed energy efficiency gains and the substitution effect (move from oil to gas in heating, for instance) all of which are gaining momentum.

Oil Demand (1963-2014 in Million barrels per day)

What this means is that the only way the oil price will rise in the near term is when there is an adjustment on the supply side and the big question how this can happen. There are two choices: the sovereigns such as Saudi Arabia or the U.S. drillers!

The Sovereigns

Clearly several of the sovereign oil producers like Russia, which generates 25% of its GDP from energy as well as as 50% of federal government revenues, are already under pressure. In other parts of the world oil revenues account for as much as 75% of government revenues (Angola, Republic of Congo and Equatorial Guinea to name but three). One of the best ways to illustrate the vulnerabilities of oil-exporting countries to falls in oil price is to look at so called fiscal break-even prices— which is the oil prices at which the governments of oil-exporting countries balance their budgets. The breakeven prices vary considerably across countries as can be seen in the diagram below. Interesting is that Saudi Arabia needs an oil price of $90 to balance its books but it has a tiny national debt (3% 0f GDP) and it has built up substantial reserves ($750bn) which suggests it has enough cash at current oil price levels for the next five years.

Fiscal Breakeven Points (in $ per oil barrel)

Source: IMF

It is however not in the Saudi’s interests to have oil prices at these low levels for everbut they are currently adamant about not-cutting production which means they want someone else to do it or they want to put pressure on other countries (such as Iran) for political reasons. The ones most likely to do cut production are Russia, China, Brazil and Mexico who between them have some 10m barrels of oil production per day which is in terminal decline. Cutting operational expenditure to these wells would be an answer but it will take time (6 months to a year). Applying pressure on the Saudi’s to enable OPEC to cut production might also work but the next meeting is six months away and OPEC were also not able to even agree at their last meeting for the need to have an emergency meeting in early 2015!

That all said there are a few possible catalysts in the month’s ahead which could change the sovereign supply situation, most notably, the new Republican led U.S. Senate which is likely to put more pressure meaning tighter sanctions on Iran which could lower global supply and then there are the Nigerian elections in February and of course the ongoing Russian/Ukrainian crisis.

The U.S. Drillers

It is easy to argue that the fall in oil price is all down to the U.S. as nearly all of the global supply growth in the last five years has come out of the tight oil basins of Texas and North Dakota. Over the last three years alone the U.S. has added an extra 3.7m barrels of daily new production to the world which is the equivalent of the production of Iran.

And much of this new oil production has come from decentralised drilling for tight oil from shale resources. The drilling machines that are used are mobile and have very quick reaction times as most wells are exhausted within 18 months. In addition, the drilling time needed for new wells to frac, so called , spud intervals are down to below 25 days. This in contrast to the larger centralised drilling the industry has been used to for the last 50 years which are expensive to start (with large CAPEX investments needed) and not so cheap to stop.

You might think that the most expensive production in terms of breakeven cost (see diagram below) such as deepwater, international shale and tar sands would be the first to get closed but this is not the case. They are the first “new” projects to be cancelled but oftentimes these projects, once they are up and running, have low marginal costs and producers are loathe to close them down knowing that it would be very expensive to switch them back on at some point in the future. Most of these producers will keep producing with the hope that oil prices will rise. The Oil Majors will balance their portfolios by cutting production where marginal costs are the lowest which more often than not will be the decentralised tight oil production.

Source: WoodMackenzie

How long it will take the tight oil producers to reduce supply is not clear but the hundreds of drilling companies out there are all profit focused, so they will react. What is not sure is when but it will be this year and we are already seeing announcements of cuts in capital expenditures in the U.S. Going forward an important catalyst will be announcements by US oil companies of their 2015 CAPEX plans which should take place in Q1. The lower they are, the better it will be for the oil price!

This article first appeared on the Energy and Carbon Blog at:http://energyandcarbon.com/oil-2015-will-blink-first-sovereigns-us-drillers/