Follow-up on the Oil Price War

Last year we wrote an article about the decline in oil prices: OPEC enters a price war with the US for market share. How has the situation evolved since then, as the oil prices sank to a six-year low in August 2015? The International Energy Agency (IEA) is the world’s most respected independent source of information about the oil market. On the 11th of September, they released their Oil Market Report.

  • Demand:

Thanks to a cheap barrel, the demand has been growing to a five-year peak of 1.7 million of barrels a day. This increase is particularly notable in developed countries, such as european countries or the United States, where people are more willing to travel by car due to the attractive price of the gasoline. The IEA predicts a demand of 1.4 million of barrels a day for the year 2016. China, which is the second largest oil consumer after the U.S. is expected to keep pace of its demand.

  • The U.S. shale industry:

Despite many efforts and innovations, the shale oil sector is still very sensitive to changing price conditions. Due to the complex method of extraction, it is one of the most expensive techniques of oil extraction. Thanks to the prices we had in the last couple of years (over 100$/barrel), investments in this sector have rocketed, with production having doubled since 2010. However, a lot of shale oil companies have accumulated a substantial amount of debt, assuming that the price would remain around 100$. At current prices, these companies haven’t been able to re-hedge, so their debt isn’t going to get smaller any time soon.

All of the seven biggest U.S. shale companies have dropping outputs. The U.S. shale oil production is expected to contract by 400’000 barrels a day, which is the equivalent of Libya’s current production.

People in the shale oil industry state that costs can be reduced drastically by producing oil from already drilled wells. However, one big disadvantage of shale wells is that the flow of oil available declines very quickly. Available data confirm this: output sinks 72% within 12 months of startup and 82% after 24 months of operation. Constant drilling is thus essential to maintain the production.

Low prices prevent companies from receiving the capital they need, which means rigs are closing one after the other: the number of active rigs decreased by 40% in a year, a level not seen since 2009. The declining output, hasn’t matched up with decline of rigs yet, but eventually it will.

  • How about the OPEC:

OPEC, with its 12 members, is the most powerful organization of oil producing countries. They know everything there is to know about oil, and that includes the technology involved in shale industry. When prices began to decline last year, OPEC members decided to maintain its oil supply. They wanted to avoid market share losses triggered by the cut back of production in the two oil crisis of the 1970s. But the data show that the OPEC went one step further and increased its supply by more than 1 million barrels a day in the second quarter of 2015, to a peak of 31.51 million barrels a day. This was an offensive strategy aimed at lowering prices even further. So far it has been a  successful attempt to ruin  the economic model of shale oil companies. However, as every price war, the measures taken to weaken the opposite side, always have effects on both sides. OPEC members, such as Saudi Arabia are also inclined to fiscal problems: the Kingdom is consuming its foreign currency reserves more quickly than the shale production is declining, for the moment. Nevertheless, OPEC members continue to produce oil relentlessly: Saudi Arabia, UAE and Iraq are close to all time high supply rates.

  • Other players in the game:

The price decline has not affected the U.S. shale oil industry only. Other producers around the world have had to adjust as well. Oil fields are being exposed of closing as companies try to anticipate and reduce losses, from these heavy investments. Outputs in the North Sea and in Russia have diminished, and Shell recently announced it was abandoning its controversial plans to drill for oil in the Arctic – not because it was controversial, but because they didn’t find enough resources and the operation wouldn’t be profitable. Canadian production dropped to a 20-months low, under 4 million barrels a day.

The oil supply provided by  Non-OPEC members is set to crash next year by the largest amount in 24 years: a decline of 500’000 barrels per day is estimated.

Let us not not forget the increasing role of the terrorist group ISIS in the oil price war. As it is present in oil producing countries, ISIS is now in control of 11 oil fields between Syria and Iraq and they recently attacked an oil port in Libya. As one can expect, they became active in the oil smuggling business. They sell oil for 20$ a barrel, an operation which turned out to be very lucrative: the U.S. State Department, in their most conservative estimates, say that ISIS has  oil revenues of 8 to 10 million of dollars a month.

  • Conclusion:

It is evident that the OPEC is seeking submission. It wants to show to world that they are the only true suppliers of oil, at any price level, on the contrary of the opportunistic but fragile US shale oil industry. It is a warning for U.S. shale investors, that every time they put more money in the sector, the 12-members organization will boost production, in order to crush anyone who dares to confront them. And they have the resources to do so: OPEC has an additional capacity of 2.27 million barrels a day, 86% of it coming from none other than Saudi Arabia. As the International Energy Agency says: “ On the face of it, the Saudi-led OPEC strategy to defend market share regardless of price appears to be having the intended effect of driving out costly, inefficient production.” Non-OPEC countries seem to have no other choice than to cut back production if they want to stop the decline in oil prices. But it will also have some repercussions on the economies of OPEC members.

 Marc Zaidan

 

SOURCES:

Cover Photo: http://www.economist.com/news/leaders/21635472-economics-oil-have-changed-some-businesses-will-go-bust-market-will-be

[Fig1]: https://www.iea.org/oilmarketreport/omrpublic/

[Fig2]: https://www.iea.org/oilmarketreport/omrpublic/

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