By John Richardson
THE bricklayer came around to my house three years ago, quickly surveyed the extent of the job, drew a sharp breath, and said, “It’s going to cost you at least Aus$4,000.” And that was after a four-week wait to get a quote.
How times have changed. Last week, the same bricklayer popped around immediately after my call and quoted Aus$2,000 to build a wall and a rockery in my back garden. We are in negotiation for something south of Aus$1,500. This demonstrates the difference that the collapse in the iron-ore price has made to the West Australian economy.
Will the bricklayer still make money if we finally do a deal? Very definitely yes, based on today’s labour and raw materials costs.
It the same story in the oil industry as the above chart from the US Energy Information Administration’s (EIA) latest month report illustrates. The EIA writes as follows:
In the third quarter of 2016, a group of publicly traded global oil companies reported the first quarterly profit from upstream production business segments since the fourth quarter of 2014, according to recently released earnings statements from 91 companies. Collectively, the group earned almost $2.3 billion in the third quarter when front-month Brent crude oil prices averaged $47/b. In the same period in 2015, when prices averaged $51/b, the group lost $54.1 billion.
Since the fourth quarter of 2014, many companies have written down the value of their assets to reflect lower oil prices, which reduces earnings in the quarter in which a company recognizes the write-down. The increase in earnings this year is partially attributable to a reduction in asset write-downs, which declined 80% year-over-year. Additionally, company reductions in operating expenses were greater than the declines in revenue, contributing to higher profitability.
The EIA adds that improving financial conditions in the US shale-oil industry had resulted in production being more resilient than expected, and that this could lead to production being expanded in 2017.
The thing is that you didn’t have to wait for this month’s EIA report to work this one out. It has been clear since late 2014 that the global oil industry would pare-back costs, find smarter ways of financing itself, and find cleverer ways of producing oil.
The most outstanding evidence of improvements in the efficiency of production is of course in the US shale-oil sector. Pioneer Natural Resources, the Texas-based company now says that it production costs range between $2.15/bbl – $12.27/bbl in the vast Permian Basin US shale-oil field.
Further cost savings inevitable
This process won’t stop. In fact, I think my brick wall and rockery will cost me an awful lot less in a year’s time if I decide to wait that long. Similarly, oil producers will continue to trim costs in order to stay in the red. Here is why:
- The dollar is going to get stronger as US interest rates, and interest rates globally, rise. A stronger dollar will make oil less affordable for buyers. And the firmer greenback is likely to trigger a global economic recession as a result of the exposure of emerging markets to US dollar-denominated debt.
- Oil producers could choose to cut production rather than further trim their cost bases, sure. But I believe that the industry will recognise that this would be entirely counterproductive because 1.) In a global recession, people want to buy less rather than more crude and so production cuts would just lead to a loss of market share, 2.) Consensus thinking will finally shift to recognising that we are about to reach, or have already reached, Peak Demand Growth for oil because of demographic and environmental reasons.
This could well combine to drive oil average oil prices lower in 2017 than in 2016.
In the short term, of course, oil prices have rallied as a result of last week’s decision by OPEC to cut production for the first time since 2008. But the problems that have since emerged in effectively implementing the deal reflect these realities: Chasing market share and constantly lowering costs are the only strategies that make sense in today’s oil market New Normal.
Difficulties in getting the deal to work include the jump in OPEC’s output from 33.6-33.8 million barrels per day (mb/d) in October to a record high 34.19 mb/d in November. The increase was the result of higher output in Angola, Gabon, Indonesia, Libya, Nigeria, Iran and Iraq.
As Nick Cunningham writes in this excellent Oilprice.com article:
If OPEC is to succeed in bringing production down to its stated target of 32.5 mb/d by January, it will now need to cut 1.7 mb/d, not just the 1.2 mb/d that it announced last week. But a few of those countries (Libya, Nigeria and Indonesia) are exempted from the limits agreed upon in the latest deal.
That means that the rest of OPEC will need to shoulder steeper cuts if the cartel is to hit the 32.5 mb/d threshold. However, the group did not discuss this contingency – who should cut even deeper – so there is little reason to think that any individual member will voluntarily cut more than they agreed to just so that the collective output comes in lower.
Venezuela – one of the OPEC deal’s strongest supporters – produces around 500,000 barrels a day ( bbl/day) of heavy oil, which has been left out of the agreement.
Russian production hit a post-Soviet high in November of 11.21 mb/d, up around 500,000 bbl/day in August. This takes the shine off the Russian commitment under the OPEC deal to cut 300,000 bbl/day of production.
“Will Russia cut 300,000?” former Saudi oil minister Ali al-Naimi was quoted as saying last week. “I don’t know. In the past, they didn’t.”
And very tellingly, al-Naimi said of the prospects for the deal in general: “The unfortunate part is we tend to cheat.”
The “Comfortable Middle” Cannot Be Your Only Scenario
I may be wrong, of course, on my call that oil prices will on average be lower in 2017 than in 2016.
What is not in doubt, though, is that you need scenarios that are built around these three assumptions:
- $25/bbl oil = Collapsing demand – Emerging markets submerge, and developed markets slow dramatically as stimulus-created debt has to be repaid.
- $50/bbl oil = Comfortable middle – Stimulus policies prove to have worked, demand recovers, project cancelations and revived growth prospects create a balanced market.
- $100/bbl oil = Continuing tension – Economic recovery stalls as geopolitical risk rises along with the potential for supply disruptions.
The comfortable middle assumes that the world in 2017 will be fine. But nothing from Brexit to the issues surrounding Chinese debt to Donald Trump’s election have suggested that this is going to be case.
You must therefore plan for all of these three outcomes and model what this would mean for petrochemicals prices and margins. Barring unforeseen news developments, this will be the subject of my post on Monday when I shall provide you with three scenarios for linear low-density polyethylene.