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Digging-in time

The short-term fundamentals look dire. But producers must not panic

John Hill owns a small company producing about 300 barrels a day of oil in eastern Alberta. Extraction involves fracking and is expensive. Hill needs $50 a barrel to keep his back-office staffed and his oil flowing. Costs are sticky and reducing them brings decisions about whether to spend $1,500 or so on regular lubing and maintenance or skip a month. 

Hill, not his real name, plans this year to increase production to 800 b/d. He needs to lay a short pipeline to do this and is searching for investors to fund the $1.4m outlay. Why, when his business loses money with each barrel it produces, does he want to double down? “I need to prove to the bank that I can manage this asset better than the next guy.” That means keeping the oil and at least some cash flowing. His lender, not the market, is Hill’s master. Thousands of North Americans running small oil operations across the continent - from stripper wells to small upstart tight oil frackers - would understand his motivation, one that has kept US supplies ticking higher longer than most expected. 

The biggest oil producers in the world are still doing something similar. Despite a 75% crash in Brent prices since mid-2014, output continues to rise. Deferments are mounting and capital budgets are dwindling, but the supply-side impact is only starting to be visible. US oil output in the week ending 15 January was 9.235m b/d, higher than in the same week last year. But the trend is down. Canadian oil sands production still chugs upwards, but no new projects are now possible. More barrels continue to flow from the North Sea and Russia, but only for now. 

Opec remains exceptional. Production of 31.71m b/d (excluding Indonesia) is about 0.7m b/d above demand for its crude in the first quarter. The imminent rise in Iranian exports will widen this gap. The International Energy Agency (IEA) talks of a global market drowning in oversupply. 

Now demand, expected to grow by a relatively healthy 1.2m b/d in 2016, is another worry. In 2014, when Saudi Arabia decided it would not cut supply to prop up prices, it thought cheaper oil would strengthen the global economy and thus oil consumers. That seemed true last year, when consumption roared higher. Increasingly, though, it looks like prices were left too high for too long, causing fundamental - if as yet poorly understood - shifts in consumer behaviour. Electric cars (and better batteries to power them), tighter fuel-economy standards, more aggressive climate-change policies, and moves towards fuel substitution are all legacies of a decade of soaring oil prices that may not be undone by a couple of years of cheap crude.

In the shorter term, anxiety about the Chinese economy will be a central theme in all markets during 2016, a year that is still expected to see oil’s supply and demand fundamentals start to balance. The bearish nightmare would see oil prices pushed back by macroeconomic headwinds, further depressing capital-spending plans, budgets and cash flow, increasing the sector’s debt, and forcing thousands more engineers and geologists out of the industry.

These are genuine risks - and they will be exacerbated if Iran’s return to the market triggers a damaging price war between the Islamic Republic and its Gulf Arab rivals.

Oil's long-term mean inflation-adjusted price since the 1970s has been around $50/b. Executives and investors in a cyclical industry such as oil should keep their faith in economics laws

But it doesn’t need to pan out this way. Oil’s long-term mean inflation-adjusted price since the 1970s has been around $50/b. Executives and investors in a cyclical industry such as oil should keep their faith in economic laws. Painful adjustments now are inevitable - especially for North America’s marginal producers - but when M&A activity picks up it will bring economies of scale to the sector, further driving down costs to leave a leaner industry. Some analysts expect prices to trade above $70/b in 2017. If so, rising productivity could mean margins are stronger then than they were at $114/b three years earlier.

What the industry can least afford is a spike in prices. Such volatility would do nothing to assure lenders now staring at barely serviceable debts in the US upstream, but it would renew consumer fears and speed up the transition away from oil. Companies must cut the froth where they can - their shareholders will demand it. But however counter-intuitive it seems at $30/b they must also keep exploring, keep producing and keep building pipelines.

Oil’s future isn’t as bright as that for other fuels, but geological depletion, population growth, and more global trade are trends that will continue to underpin its central role in the world’s economy. Geopolitical risks, meanwhile, are as great a threat to supply now as they have been in years. Thinking today’s market conditions will endure is as short-sighted as the assumption that oil would always remain at $100/b. The market will turn, as it always does. The coming months could be rough for anyone who sells oil. Producers should not panic, but dig in and wait for the correction to end. 

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