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Even lower prices await the oil industry

The market is at last adjusting to the fundamentals of weak demand growth and burgeoning supply

Is the 40% drop in oil prices since June a correction or a crash? Anyone in the oil industry hoping the slump in the second half of 2014 will be reversed soon should probably think again. Even lower prices await. A return to $80-a-barrel oil, let alone $100, looks a long way off.

Rising supply and weak demand growth made the recent decline inevitable. The supply gains continue to be startling. US output in mid-November was 1 million barrels a day (b/d) higher than at the same point in 2013. Thanks to the Eagle Ford and Permian, Texas on its own added 660,000 b/d to supply by the end of September.

In a global context, that means that in just three quarters Texas by itself accounted almost entirely for world demand growth in 2014, which the International Energy Agency (IEA) expects to be just 700,000 b/d. Triple-digit oil prices could not survive this.

Despite the drop in prices, however, supply growth does not seem likely to end. It might slow next year, said Adam Sieminski, head of the Energy Information Administration (EIA), on 9 December, “but annual output is forecast to still increase to the highest level since 1972”. He expected prices to remain high enough in 2015 “to support new drilling in the major shale areas in North Dakota and Texas, which account for most of the growth in US oil production.” Indeed, the EIA reckons output from the Bakken, Eagle Ford and Permian basin will rise again in January by 103,000 b/d. Per-well output is increasing in those key plays. In the Bakken alone, wells will in January produce at least 10% more than they averaged in 2014.

Area of concern

Those will be worrying numbers for Opec and anyone else who thought a dip in drilling activity and upstream spending would curb supply. Although Continental Resources, ConocoPhillips, Apache and others have all already announced cutbacks – and more will come as firms publish their budgets for 2015 -- the sector has been working so fast in recent months that a backlog of wells remains uncompleted, around 610, equivalent to three months of activity, according to Citi, a bank. The cutbacks, moreover, will likely refocus firms’ attention on the best prospects, meaning “productivity gains could see a jump in 2015, which could offset some a fall in capex/rigs”, says the bank.

All of this makes Opec’s decision at the end of November not to cut output a colossal gamble. If the plunge in prices does little to stop US output growth, the group’s members will wonder why Saudi Arabia overruled any defence of $100/b oil. Outside the Gulf, none of the Opec countries can afford for the recent rout to turn into a multi-year downturn. When Opec eventually decides to cut, it may end up ceding market share to target a price much lower than one it could conceivably have defended in November.

For now, Saudi Arabia looks determined to stay the course. Ali Naimi argued in Vienna that a period of low oil prices was needed to choke off rising US supply. The only way to test the theory is to let the market fall.

Already, that strategy is plain in the kingdom’s marketing, too. In early December, it slashed its official selling prices (OSPs) for January shipments to the US and Asia. The OSP discount for Asia was the biggest since 2002, according to Reuters data. Those kinds of tactics from the kingdom will strengthen the view that it is now engaged in a price war, taking on all comers. These include not just US tight-oil producers and Canadian oil-sands developers, but fellow Opec members.

Aside from the irritation of rising US output, Saudi Arabia could soon face increased production from Iran, should sanctions be eased next year, and Iraq. The agreement between Baghdad and the Kurdistan Regional Government in early December will almost instantly add another 300,000 b/d of exports from Iraq’s north. In the south, output should rise as export bottlenecks ease in 2015, too. Libyan output could also rise quickly, worsening the supply global supply glut. (The country’s political chaos could just as easily bring an output collapse again.) 

This could all loosen the market significantly in 2015, with the first half of the year looking especially vulnerable to further price drops. Some Wall Street forecasters now see Brent dropping into the $40s before it finds its bottom. The IEA expects demand to have reached 93.55m b/d in the fourth quarter of 2014, but forecasts consumption of just 92.64m in the first quarter of 2015 and 92.72m in the second quarter. Extra North American oil, cheaper Saudi exports, rising supplies from Iraq and possibly Libya and Iran would pour into this weak market.

A trough in prices through the second half of 2015 could spur Opec into action at its next scheduled meeting in June - or force the group into an emergency meeting before then. But then Opec will meet the same dilemma it faced in November. Cutting to raise prices would surrender more market share, while reinforcing the economics of non-Opec supply, giving it a timely shot of adrenaline. Cuts might not work, if all they did was just raise the price enough to encourage more non-Opec supply. A price crash by then would start to look a lot more like a correction, or even a slump. 

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