Low oil prices, market death and looming crisis in the oil patch
A number of stories over the past week that I don’t have a full analysis for are interesting enough that I want to mention them in a potpourri post of market news. I don’t have a view on all of these stories but I do think these are some of the things we should be watching. I am going to make this post about the oil patch and run the others in a separate post because I have a stronger view on the oil situation.
The still deteriorating situation in oil markets
First, this morning, I ran into a story from Andy Lees at the Macro Strategy Partnership which highlights a proposal by Petrobras to divest itself of pre-salt fields in order to raise cash to pay down debt. Andy also mentioned Norway’s Statoil’s plan to cut 10% of its headcount to reduce costs as oil prices have plummeted. Clearly, the cuts continue in the oil patch but we are nowhere near where we need to be to get the supply-demand balance right and this situation makes an analysis by ARC Financial Resources Peter Tertzakian very relevant.
Let me summarize the crucial lead-in to what Tertzakian is saying in my own words.
In July of this year, the supply demand balance for the global oil market had shifted so much in favour of buyers that a precipitous drop in oil prices began.
There were both supply and demand reasons behind the imbalance, but the big factor on the supply side was the addition of high cost production from tight oil formations in the US.
When prices began dropping, Saudi Arabia, as the traditional conventional oil swing producer, could have cut production. But Saudi market share had fallen so much in recent years that the Saudis were loathe to cut production, knowing that even other OPEC members were likely to ‘cheat’ and maintain production.
So the Saudis started a price war to win back market share, with the Saudis and their OPEC allies deciding to maintain output high last November despite oil prices being cut in half.
This reaction meant higher cost and indebted producers (like shale oil producers and Petrobras) were now under significant financial pressure because high cost producers were at price levels approaching or below marginal cost and indebted producers saw their revenue available to service debt cut in half.
What one initially does when this happens is two fold. First, one cuts capital expenditure wherever one can. This has happened globally, not just for high marginal cost producers, but for everyone. Even Statoil is feeling the pressure now, as we see head counts coming down a massive 10% across the board, with engineering and technical staff down 20%. But for indebted companies this is not enough. And we know that the increase in debt associated with tight oil formation oil and gas production has been massive since the financial crisis ended. These companies must find a way to service this debt – and the obvious thing to do first when revenue declines is to actually increase production, not decrease it.
So financial distress leads to an increase in production, which then leads to the increased stockpile of crude we have seen recently. The most recent report from the US Energy Information Administration showed US crude stocks rising in the week to April 3 by 10.9 million barrels. That’s the largest weekly build since at least March 2001. And now crude oil stocks in the US are a record 482.39 million barrels. And this inventory build up has been extremely precipitous. This is extremely bearish irrespective of whatever else may be happening.
(Source: National Post)
But we also know that the Saudis are continuing to ramp up production as well. Saudi oil minister Ali al-Naimi said early last week that Saudi output, after posting a record high of 10.3 million barrels per day in March, would remain around 10 million until and unless non-OPEC members cut production. Iraq and Libya also increased output for March, adding still further to OPEC production levels, which came to 31.5 million bpd in March. The Russians, and US and Canadian producers are also increasing output, setting the stage for continued inventory builds throughout 2015.
What comes next then? Market Death. That’s the term Peter Tertzakian uses. He says phase 1 of a price war is dominated by production increases due to the need to pay one’s bills. And that basically means you see a massive uptick in production and inventories as we have seen, despite the cut in capital expenditure. in phase 2 comes what Tertzakian calls Market Death. This is simply the period when we see business failures en masse, a death of enough parts of the supply market to bring supply and demand into balance.
In Tertzakian’s view, the Saudis have not seen enough market death to take their foot off the production accelerator. They can weather the storm but want to press the issue because their objective is to kill the high cost producers and regain market share. Other producers in a less advantageous position must also maintain production too – or face insolvency.
At $50 a barrel, where we are now, the oil industry cannot grow output. It can’t even sustain capacity. And so it is only a question of time before the supply-demand imbalance is cured. The Saudis will survive the war under any circumstances. The question is who else survives. And I believe the key is the degree to which demand plays a factor. Many of the higher-cost producers have hedge in place to protect their production revenue through this year or early 2016. When these hedges come due, if we are still at these levels, these producers are going to feel serious pain.
Moreover, the clock is ticking in terms of the balance sheets of producers, who have to account for oil assets at the average price for the last 12 months. When July hits, we will be in a situation where there are going to be big markdowns to oil assets on balance sheets and that will negatively impact, loan collateral ratios and borrowing capacity.
In essence, there is a ticking time bomb lurking at the heart of the oil industry right now. And the only thing that can defuse it is an increase in global demand. My sense here is that global demand is not going to rescue us. The trade numbers out of China this morning showed a double digit decrease in both exports and imports, indicating sluggish global demand growth that I believe will persist for some time to come.
The likely outcome here is market death on a mass scale in the second half of 2015 and in 2016. We saw the early jitters from market death last year as the high yield bond markets reacted to the decline in oil prices. But things have stabilized since then. However, I believe we will see an oil market crisis develop as market death takes hold. And the baseline scenario here has to be for market volatility and some degree of contagion. It is still early days s it is not yet clear where prices are headed, where contagion will develop, and what the real economy impact will be. It isn’t even clear yet that the crisis is a lock. But this is a situation that has the potential to be a significant source of wider market risk which we should be watching very closely.
I will have the other headlines for today at some point later in the day or early tomorrow AM.