That Sinking Feeling

Friday, 08 January 2016 09:29 Written by 

Oil prices have started 2016 with a deep dive, with front month Brent crude oil losing around $4/bbl this week, or around 10 percent of its value, despite rising political tensions between Iran and Saudi Arabia.  At the time of writing, the price of Brent is just over $34/bbl, a level last seen in 2004.  Clearly the market is focused more on the sustained level of oversupply and fears of an economic slowdown spurred by the Chinese stock market meltdown than on sparks flying between the two OPEC powerhouses. With global stock levels rising by over 500 million barrels last year and continuing to rise despite unsustainably low current prices, crude oil traders are nervous and short positions have increased to recent record levels, pointing to lower price expectations in the months ahead.

that sinking feeling 2

Much attention has been focused on the US shale oil sector, which has been defying predictions of collapse for more than a year now.  While output has slipped in recent months, supply is still abundant, production in some quarters is still rising and oil continues to move to markets in the US Midcontinent – at least for now.  A successful stock market placement by Pioneer Natural Resources this week, raising $1.4 billion dollars to sustain an expansive capital investment programme and boost output, is a vote of confidence in the sector despite lingering concerns for the viability of some smaller players.  A key question remains as to whether US tight oil producers will have a soft landing, with production slipping only modestly, or a much harder time with output perhaps falling by another 1 million bpd.  On current evidence, the former seems more likely, which is a challenge to producers elsewhere.

The current price environment is bad news for the oil majors, who have already hacked away at their capital spending programmes with a view to sustaining dividend payments and turning net cash positive by 2017.  The biggest impact here will be on longer-term growth of conventional production, and potentially on the oilfield service companies hired to develop new resources.  If 2015 was tough, 2016 will be tougher, with an even sharper focus on cost control.  A test of oil prices in the $30/bbl range will drive producers to stress test their new projects at hurdle prices far lower than in the recent past. Having squeezed costs over the past two years, non-OPEC upstream will become much more cost competitive, which heralds an extended era of sustained lower marginal cost crude oil. 

Meanwhile, refiners continue to benefit from cheaper energy and strong consumer demand, especially for gasoline.  The mild winter in the Eastern US and parts of Northwest Europe has weakened demand for distillates, which are accumulating in storage in Europe, but strong gasoline cracks are driving refiners to sustain output and delay maintenance with a view to “getting while the getting’s good”.  This is a key opportunity for refiners to invest in operational efficiencies to be better prepared to weather then next downturn when it comes.  Margins remain stronger today than before the oil price crashed, though refiners will be wary of an economic slowdown which would curb demand growth for refined products. 

KBC Energy Economics sees oil demand growing by 1.5 million bpd in 2016 and 1.9 million bpd in 2017, but these figures are dependent on sustained economic recovery in Europe and growth resuming throughout North America, Asia and the Middle East.  Growing demand should serve to tighten up the oil market by late 2016, with price recovery following on.  KBC sees prices remaining in the low $30/bbl range in Q1 before rising through the rest of the year to finish around $57/bbl at year end.  Refining margins are likely to remain robust at least through the ‘driving season’ in the Northern Hemisphere summer. 

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