Andreoli on Oil & Fuel: Low oil prices cooked the goose that laid the golden egg

If it feels like global oil and fuel markets are in a constant state of turmoil—it’s because they are. And as we enter 2016, markets could not be more unstable.

The good news for shippers, at least in the short term, is that oil and fuel prices are lower now than they’ve been at any point over the last decade. The bad news is that these low prices cooked the goose that laid the golden egg, and now threaten to further destabilize many of the world’s leading oil exporters.

Through all of last year, low prices forced investment in the Bakken, Eagle Ford, and other shale oil plays to contract. Drilling rig counts plummeted, and it was only a matter of time before oil production from these fields followed suit.

As I forecasted in my column “Another boom goes bust” back in April of 2015: “Domestic oil production will likely begin declining in May.” As it turned out, my forecast was off by a month or two. After growing for 60 consecutive months at a compound rate of over 30% per year, U.S. Energy Information Administration (EIA) data indicate that shale oil production peaked in March after growing by 1.2 million barrels per day in 2014 alone.

Since peaking, shale oil production has been declining at an annual rate of nearly 12.7% per year—or 1.12% per month. Over the 12 months ending in January 2016, nearly 640,000 barrels per day left the system.

In that same column I also wrote that “forces outside the United States could cause the price slump to persist much longer than any shale oil producer is prepared for.” These forces threatened to intensify a burgeoning glut that was initially caused by shale oil production. I was making specific reference to the possibility of oil production from Libya and Iran coming back to the market. As it turns out, the current glut—which I estimate to be between 1 million and 1.2 million barrels per day—was not driven by either of these countries.

While most fingers have pointed to Saudi Arabia as the source of the current oversupply, and it’s true that the Saudis increased production over the course of 2015 to the tune of 400,000 barrels per day, the truth is that Iraq played a much larger role. Oil production in Iraq increased by nearly 1 million barrels per day between January and December.

This is important because Iraq’s growth is a product of continued investment that has occurred since Saddam Hussein’s ouster. Since 2007, Iraqi production has increased at a compound rate of 6.3% per year, and barring the unforeseeable, Iraqi output should continue to grow through 2016.

Looking forward, I fully expect that low prices will continue to wreak havoc on the oil industry, and the pain will certainly be disproportionately felt by two groups in particular: shale oil producers who face the twin challenges of expensive drilling and rapid oil production decline rates; and international oil companies (IOCs) engaged in expensive and relatively high risk exploration and production such as deepwater, ultra-deepwater and arctic producers.

As a byproduct, I expect many of the shale producers who are swimming in debt to be acquired—or worse yet—file bankruptcy, while IOCs will at the very least be forced into slashing exploration and production budgets and cut costs throughout the corporate structure.

Oil prices are, of course, a function of both supply and demand, so any price outlook must take into account an outlook for demand as well as supply. While low prices and a relatively high functioning economy should continue to push up domestic consumption, the United States is an island among struggling Organization for Economic Co-operation and Development (OECD) economies that are likely to see oil consumption remain flat—or even decline.

Among the non-OECD countries, China is the largest consumer of oil, and as the growth rate of the Chinese economy continues to slow through 2016, there is every indication that oil consumption growth rates will follow suit.

Beyond China and Japan, which is a member of the OECD, India is the fourth largest consumer of oil, and consumption there is expected to grow at a moderate pace between 3.5% and 3.75%, thus elevating global demand by somewhere between 145,000 and 155,000 barrels per day.

Russia, Saudi Arabia and Brazil are the only countries left on the list of top 10 oil consumers that have not been discussed and are not in the OECD. From a demand perspective, the outlook for consumption in each of these countries has been severely handicapped by the low oil prices, which have crushed these countries’ export bases. All are in recession, and none are expected to emerge from recession so long as prices remain low.

Ironically, there’s a perversion of incentives here. As prices fall, federal budgets are challenged, and they push for higher volumes to counter the lower value. This, of course, negatively affects the price. At any rate, there is every reason to expect consumption from these countries to decline as economic output contracts.

Looking forward, the key to where prices are likely to go has everything to do with how the current oversupply develops over the course of the year. Slow growth in demand certainly doesn’t help support higher prices, and while I expect U.S. production to contract between 400,000 and 600,000 barrels per day, this decline could easily be countered—or even be overwhelmed—by Iranian oil.

Depending on how the remaining sanctions affect the ability for Europe to secure Iranian oil shipments, we should expect to see Iranian output increase by at least 300,000 barrels per day, but the actual increase could be as high as 600,000 or even 800,000 barrels per day.

And Libya remains a potentially very disruptive wild card. Currently, unplanned outages in Libya amount to more than 1 million barrels per day, and it should be expected that anywhere between zero and 1 million barrels per day come back online over the course of the year.

In all, even under the most aggressive assumptions, the current oversupply is not likely to be worked off over the course of the year. This suggests that although there will be significant volatility, prices should follow a horizontal trend, meaning that we should expect prices to remain around $30 per barrel.

But herein lies the rub. Thirty dollars per barrel is not high enough to support producers, and, more importantly, the federal budgets of the most important oil exporters including Russia, Saudi Arabia, Iraq, Iran, the UAE, Kuwait, Venezuela, etc. All of these countries are already in a state of severe economic disruption, and it is only a matter of time before these economic problems bubble over.

Lest we forget, the Arab Spring had its roots in the “food riots” and morphed into social revolutions that left gaping power vacuums that have in too many cases come to be filled with radicals.

Whether it’s through Adam Smith’s invisible hand wiping shale wells off the map, or through one or more geopolitical events, the system will experience a price correction, and the longer prices remain low, the more severe that correction is going to be.
In other words, good news for shippers today will likely lead to elevated pain tomorrow. My advice: Keep fuel costs at the top of the priority list and continue to focus on squeezing efficiency out of the system.