I attended the September 15 FEI meeting along with a number of my Aventine Hill colleagues. Andrew Slaughter, Executive Director of the Center for Energy Solutions at Deloitte, was the keynote speaker addressing the timely topic of “The Oil Market Downturn and Recovery Outlook”. Mr. Slaughter gave an excellent overview of the current oil and natural gas market situation. He also provided insights into what the future holds for energy prices. Here is a summary of Mr. Slaughter's talk followed by comments from my own perspective.
Current Energy Market
Everyone is familiar with the current high production and lower prices faced by energy markets. Saudi Arabia’s comment last Thanksgiving that market share and not price is the new game sent a message to the market and extended the anticipated time period for lower prices. The Saudi reiteration of their market share comment in June of this year lowered prices following the brief uptick in April and May, effectively dashing any hope for a quick recovery in prices.
Record investments in US reserves and production, most of it in unconventional sources (shale), has more than doubled from the 2004-2008 time period to $850 billion between 2009-2013. While the rig count is down 35%, shale oil production has not followed the decline in rig count and has held up until recently. The investments in shale oil have resulted in improvements in technology and enhanced efficiencies which have resulted in increased shale oil production. Shale oil production response to lower investment is not completely known at this point in time.
Overall, industry capital expenditures are down 25%; the industry has lost 20% of its market value and taken $180 billion in impairments. The outlook for improvement is tempered by anticipation of Iran production and concern with lower Chinese demand, the combination of which has resulted in increased volatility in the market.
Previous Oil Price declines
In the late 1980’s, OECD demand fell as a result of higher prices. As supply increased, prices dropped, but subsequently rose as OPEC adjusted production. The Asian crisis in the late 1990’s caused OPEC to adjust supply and the resulting lower price environment was relatively short. During the 2008-09 financial crisis, demand fell and OPEC again, adjusted production. The market fundamentals are different this time as OPEC is not adjusting oil production and, so far, oil shale production has not dropped to balance the market. The previous declines and recoveries were somewhat “V” shaped, but the current situation is departing from this norm.
A ceiling for oil prices is now estimated to be based on oil sands production, which need $80 oil to break even. The good news is that as oil prices go down, demand goes up and the major world energy forecasters (IEA, EIA, and OPEC) are all now projecting increased demand in 2016. There is not much downside next year, except Iran supply and China demand.
Natural gas prices have been low for a while as supply has increased more than demand. Exports of US LNG will impact the supply to the US domestic market, but prices are expected to remain low.
Near-term Sign Posts
- Rollover of hedging positions: Some companies are benefiting from previous hedges at a higher price. These will roll off and be done at a lower price or not done at all.
- Higher interest rates will adversely impact the ability to raise debt capital and meet higher interest payments, reducing the financial flexibility in the sector.
- The bank response to lower cash flow and higher borrowing costs will include tighter credit limits, lower redeterminations for reserve based borrowings, and a more risk adverse posture with loaning funds.
- Service companies have reduced costs and, in turn, reduced their costs to producers. This has improved shale economics and reduced the break-even price point.
- A tighter supply / demand balance in 2016 will limit the downside in oil prices.
Long-term Sign PostsTrends to monitor and consider in strategic planning include:
- Reforms by producing nations to incentivize production and development will provide more supply and temper oil price increases.
- Implementation of Mexican reforms will also add to the oil supply.
- Currency devaluations will make oil more expensive, as it is prices in US dollars, and decrease demand.
- Delays in mega / deepwater projects due to lower and more volatile prices will decrease supply in the short term.
Events that could have a significant and quick impact on oil prices include:
- Production cuts by major producers.
- Lifting of the US export ban.
- Iraq / Iran disruptions.
Mr. Slaughter provided a great deal of information about the current market situation, but overall, his discussion had a slightly optimistic tone. The impact on us is how we use this information in running our day-to-day business. While we might run a low price scenario for budgets and investment evaluations, the base case might be at slightly higher prices for 2016 than exist today, with increases in subsequent years.
As this low price environment might last for a while, we need to be diligent in lowering our corporate cost structure including G&A and vendor costs, improving our working capital management and making our processes more efficient and effective. Weathering this difficult time will take a concerted effort by everyone in the company, with the natural lead for this effort being the CFO.