Into the red for the black stuff

Current oil prices below $50 a barrel are insufficient to guarantee long-term supply. With U.S. shale-oil output establishing itself as a new supply source, the jury is out on an appropriate oil price level. Most market participants appear to assume it’s $60 a barrel, or slightly more. This will mean that some conventional oil production will become uneconomic, and will be replaced by unconventional supply. Until the new balance is reached, significant price volatility is likely.

The low oil price is driving oil companies to delay spending for oil-field development, with the result that reserve additions no longer balance the oil extracted every year. Global oil reserves have thus fallen for two consecutive years, a first in the industry. Additional reserves in the U.S. almost offset declines in the North Sea, Iraq and Guinea in 2014. Reserve declines in Brazil last year were only offset by Norwegian additions, which led to a stronger reserve contraction globally.

Falling oil reserves indicate that more price turmoil is likely. Only economically exploitable volume can be booked as proven reserves, making the metric a direct function of the low oil price. Reserves have also fallen as low oil prices force companies to cut the spending needed to replace annual extraction quantities with new finds. Insufficient discoveries will lead to higher production costs, supply outages and subsequent price spikes in the midterm.

Low oil prices
Low oil prices (BBC)

Shale will be among the few sources of oil able to compete with Middle Eastern crude supplies if the price per barrel stays below $50 until 2020. While oil production costs are the world’s lowest in the Persian Gulf region, North American shale producers are still improving cost efficiency at new wells. Their ability to flexibly raise and lower output as the price levels allows may also enable them to remain profitable in a low oil price environment.

M&A is AWOL

Deal making in the oil industry has remained subdued in the last two years as volatile oil prices led potential buyers to sit on their hands. A more stable oil price may better align buyers and sellers on asset values, boosting M&A activity. Persistent low oil prices might also force oil companies to dispose of assets as debt levels escalate. Companies with more resilient balance sheets and cash to spare may ultimately decide to take over the more vulnerable companies, possibly at a discount.

Sell!, Vendre!, Verkaufen!

An impetus to deal making in the oil and gas sector may come from European utilities that are selling upstream assets in order to focus on their core businesses of power generation and distribution while retaining cash and reducing emissions.

EU utilities are selling upstream oil and gas assets to maximise cash and cut emissions. While E.ON and Enel may be working on a full exit, Centrica and Engie are only seeking to downsize to E&P in EMEA. Gas Natural, SSE and EVN have indicated no plans to change the scope of their E&P business. Most utility disposals would involve specific assets, and not whole subsidiaries, such as RWE’s E&P sale to LetterOne. Should EDF decide to exit E&P, it would sell Edison’s upstream assets and keep the supply business.

With oil prices low, the valuations placed on exploration and production assets being sold by EU utilities are proving attractive. Previously, high volatility in oil prices and disagreement about the outlook hampered deals. But the number of transactions has recently increased. Though the oil price recovery is taking longer than previously predicted, analysts still estimate crude will advance by more than 50% by the end of 2018.

Low oil places place strain on Saudi cash reserves

HSBC analysts said that for the month of February, Saudi’s foreign-exchange holdings dropped by more than $9 billion, falling to their lowest level in nearly four years, and are continuing their slide lower. Reserves had fallen by £14 billion in January. The amount of reserve assets held by the Saudi government stood at $593 billion, more than $150 billion (£104 billion) down from its recent peak in late 2014. As a result, for the second time in four months, the ratings agency S&P downgraded Saudi Arabia’s debt rating, which makes it more expensive for Saudi Arabia to borrow money.

Saudi budget revenue and expenditure (USD bn)
Saudi budget revenue and expenditure (USD bn)

Saudi Arabia has begun releasing information on its ambitious plans to reform its economy away from oil dependence. Part of the plan includes offering up shares of state-owned oil company Aramco in what could be the largest-ever initial public offering.

A Saudi Aramco initial public offering would result in a titan, with a potential value of 5x that of Apple. Deputy Crown Prince Mohammed bin Salman announced Saudi Arabia will sell shares in the Aramco parent company, including the upstream operations, rather than only the downstream unit. An IPO is planned for less than 5% of the company, and may be as early as next year.

The bulk of its value stems from the upstream unit, which holds huge crude reserves. The company alone accounts for Saudi Arabia’s 10.2 million barrels a day production, about 10% of global oil output. Aramco’s downstream assets may be worth $41 billion, which makes it the third-largest oil refining business by market value after India’s Reliance and Phillips 66.

If Saudi Arabia follows through with plans to list state-owned oil company Saudi Aramco on the local exchange, it may provide more transparency to global oil markets, given it would require an independent audit of proven reserves, which the company hasn’t published in decades. Saudi Aramco reported its own estimates for 2014 at 261.1 billion barrels of crude and condensates and 294 trillion cubic feet of gas, totalling 317 billion barrels of oil equivalent. Output was 11.7 million barrels daily in 2014.

Saudi Arabia’s strategy to transform Aramco from an oil and gas company to an energy and industrial conglomerate shows that the kingdom is preparing to make its economy less reliant on oil and forms part of a wider effort by Saudi Arabia to modernise its economy under Prince Mohammed.

Producers break-even oil prices
Producers break-even oil prices

OPEC’s decision to maintain output quotas is partly driven by Saudi Arabia’s quest to secure Asian market share. With the U.S. no longer needing Nigerian oil imports, thanks to its shale boom, Nigerian sellers are willing to sell their oil to China at a discount to Saudi crude. Russia is also looking to China. The kingdom’s share of Chinese oil imports in 2015 dropped 13.5% from 21.7% in 2011, as shipments fell by 6%. Meanwhile, China’s total imports grew by 51.4% to 33.2 million tons.

Is the low oil price set for a ‘violent reversal’ higher?

Oil rose six per cent in 24 hours and, according to one veteran trader, could be set for a “violent reversal” to much higher levels.

The steep overnight rise was driven by “short-covering” by hedge funds and other large investors, reports Reuters. This is where traders, who have recently built up a huge bet on prices falling further, are forced to switch out of bearish positions in response to an underlying upward move, accelerating the pace of increase. The shift drove US price benchmark West Texas Intermediate to close to $42 overnight, up from less than $40 a day earlier, which represented bear market territory. International oil price benchmark Brent crude rose back above $44 a barrel, up from its own bear market threshold around $42.

However, there is “little fundamental data” to support a significant uptick, ANZ Bank said, as reports still point to resurgent raw crude stocks and a massive stockpile of refined products.

But veteran oil trader Andy Hall, who runs the Astenbeck Capital Management hedge fund, is telling his investors to expect a big move higher in the coming months, reports Bloomberg. Hall, known as the “god of crude oil trading”, says July’s dip in prices, after a rally to above $50 in June, was “overblown” and that the market is “being driven by its own momentum“. He maintains that overall oil supply is much more balanced and that prices at the current level are “unsustainable“.

Low oil but still low growth

With Europe’s flagging economies characterised by low inflation and weak growth, any benefits of lower prices would be welcomed by beleaguered governments. A 10% fall in oil prices should lead to a 0.1% increase in economic output, say some. In general consumers benefit through lower energy prices, but eventually low oil prices do erode the conditions that brought them about.

China, which is set to become the largest net importer of oil, should gain from falling prices. However, lower oil prices won’t fully offset the far wider effects of a slowing economy. Japan imports nearly all of the oil it uses. But lower prices are a mixed blessing because high energy prices had helped to push inflation higher, which has been a key part of Japanese Prime Minister Shinzo Abe’s growth strategy to combat deflation. India imports 75% of its oil, and analysts say falling oil prices will ease its current account deficit. At the same time, the cost of India’s fuel subsidies could fall by $2.5bn this year – but only if oil prices stay low.

References
  1. http://www.marketplace.org/2016/04/25/world/saudi-arabia-pushing-biggest-ever-ipo
  2. Bloomberg – The world at oil below $50; Oil, Gas Industry set for M&A Spree; Utilities Hang up for Sale Sign over oil, Gas Fields in Refocus
  3. http://www.bbc.co.uk/news/business-35245133
  4. http://www.theweek.co.uk/oil-price/60838/oil-price-rally-on-petrol-stocks-draw-proves-short-lived
  5. http://uk.businessinsider.com/report-saudi-arabia-to-launch-an-international-bond-2016-5

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