By John Richardson
BEFORE you get carried away with the wholly misguided notion that we have entered into a “new normal” of oil prices in the region of $60-80 a barrel for the rest of this year, see below for a further and updated guide to why this kind of thinking is very, very dangerous. Complacency, as always, is the enemy of good planning.
And before I provide you with this latest seven-point guide to why you must prepare for great volatility in oil prices in H2, here is another suggestion: Set up a working committee in your chemicals company of people who are willing to both challenge conventional thinking on energy markets, whilst also being prepared to be challenged themselves. You do not want “yes” women or men on these committees who just agree with the boss, or people who are only good at describing what has already happened. You instead need genuinely original thinkers.
As promised yesterday, here are six issues that your new committee needs to consider.
- A rather bizarre Norwegian folk saying is apparently this, according to a Statoil executive: “Necessity teaches the naked woman how to knit”. Progress made by Statoil in boosting the efficiency of fracking illustrates how innovation in this area will never stop. The company is, for example, looking at ways of reducing the amount of sand and water used in shale-oil wells. Meanwhile, GE Oil & Gas is making use of algorithms that lower fuel consumption at wells. This reduces the wear and tear on pumps and so lowers production costs by $2-3 a barrel. What is the breakeven price of oil to keep shale-oil wells operating? Any answer I give is likely to soon be out of date as costs are constantly falling.
- Because of the nature of this technology, you can turns wells on and off in a matter of weeks. This is particularly for oil which is, in effect, being stored in unfracked rock – i.e. the “fracklog” I have discussed before. So it is not surprising that the recent recovery in oil prices has led US companies such as Devon Energy, Pioneer Resources and EOG – the country’ shale-oil producer – to indicate that they will very soon raise output.
- Globally, the oil market remains very well supplied, with daily production some 2 million barrels a day ahead of demand. Saudi Arabia produced 10.308 million barrels of oil a day last month, a record high, up from 10.294 million in March. This is a further indication that Saudi is continuing with its long game of trying to regain market share. And at the same time as the Kingdom pumps more oil, unsold exports from West Africa, Azerbaijan and the North Sea have risen to a similar level as last summer, which was, of course, just before the oil price collapsed.
- A “wild card” is Iran. If the nuclear framework deal is concluded with the West at the end of June, then sentiment alone could drive prices down. In terms of physical volumes, Iran could increase oil exports of 1.2 million barrels a day by about 300,000 barrels a day, drawn from its floating storage. That could add 1 million barrels a day to global supply within 12 months to 18 months.
- Don’t be fooled by China’s very high oil imports in Q4 of last year, and the further surge so far this year, including record-high import levels in April. A lot of this crude is going into strategic reserves as China takes advantage of lower prices. And by building domestic storage, along with acquiring ever-more oil assets overseas, it is also attempting to boost its role in global price setting. There is another reason to believe that strong shipments to China do not indicate equally strong local demand for crude, which is the rise in China’s oil product re-exports. And as Reuters points out in this article: While [China’s) refineries aren’t nearly as significant employers as steel mills and aluminium smelters, it’s possible that China’s oil companies will also be encouraged to operate at high levels as part of efforts to stimulate the economy. This raises the likelihood of excess refined fuels being exported, especially if domestic demand growth remains muted. China already has more than 2 million barrels per day of excess refining capacity, and with Asian refining margins currently higher than the average for the past year, there will be a profit incentive to export fuel as well. This is another indication that China is, in effect, exporting deflation to the rest of the world as it tries to protect employment during its very difficult, and very prolonged, programme of economic reforms. And when prices for everything globally are falling, with the deflationary cycle also gaining momentum from demographics, people will delay more and more purchases from today until tomorrow. When this happens demand for everything declines, meaning that consumption growth for crude will continue to decline in the West.
- The recent recovery in oil prices has been driven by speculators who have taken out an increasing number of long positions in paper markets. Net long positions have now risen from some 265 million barrels of oil, which was already a record high, to 389 million barrels of oil. This has enabled producers to hedge with these speculators against lower prices in H2 – so enabling the producers to maintain high levels of output, even if prices crater again. This surge in speculation has been driven by the search for yield because of low interest rates. But this might all change when the Fed raises interest rates, resulting in these long positions being unwound.
- And, finally, as I again discussed yesterday, underpinning all your analysis must be an understanding of the role that the Fed has played in returning the oil market to 19th century boom and bust cycles. You must therefore have a wide range of oil-price scenarios for H2, including another big downward correction.