The oil price’s steep fall in late 2014 and early 2015 has benefited major oil consumers such as the airlines at the expense of energy producers. The debate about where oil prices go from here is now raging. In this article, we join the “lower for longer” oil price argument and give three reasons why
Oil price forecasters have a notoriously poor track record. At the start of 2014, the average forecast was USD104 a barrel, with the price ending the year at USD55. Forecasts for 2016 are now a meaningless USD30-200.
The reasons for the difficulties lie in the drivers of oil’s spot price*:
- Much of the world’s oil is produced in geopolitical trouble spots, meaning that supply is unreliable.
- Supply and demand is finely balanced, and (until very recently) supply takes several years to increase.
*Spot price simply means the price of buying a barrel today, as opposed to a “forward price” which would be the price of buying the same barrel at some defined point in the future.
It was, in fact, the combination of these factors that led to 2014’s massive price plunge. Between 2007 and 2014, the US increased production from 1.8 billion barrels per year to 3.6 billion barrels. That increased production led to an imbalance in 2014 when it collided with a slowing rate of growth in demand from China and the expectation that Iran was coming back online after years of sanctions that prevented supply.
In 2015, forecasters are split into two camps:
- Lower for Longer: The oil price will remain around the current price for several years.
- Recovery: Within the next 12-18 months, oil will recover to over $100.
On balance, I’d tend to favour the Lower for Longer camp for three reasons:
- Supply capacity far outstrips demand, due to the recent investment cycle in new production.
- Shale oil technology advances have allowed a doubling in the oil producing capacity of the US.
- Iran will likely re-enter supply markets in 2016.
Each of these factors is considered further below. The question is, what difference does this make to Australian investors?
The first and most obvious impact is on the energy sector itself. Gas prices have historically been very highly correlated to oil prices, and as shale technology has increased the capacity for gas even more than for oil, this time will be no exception. Gas producers will face years of flat prices. Coal has already seen a halving of its price and as it is so close to the marginal cost of production, further declines are unlikely as supply will be reduced in response.
Overall, energy producers such as Woodside, Origin Energy and Santos will struggle to improve earnings in this environment. Service providers such as Worley Parsons and Ausdrill also face headwinds due to the lack of investment that follows the lower for longer forecast.
The winners from a lower for longer oil price are the consumers of oil. Qantas and Virgin are the clear winners, given that around one-third of their cost bases are made up of jet fuel costs. Other winners include companies such as transporters, paper & packaging manufacturers and surprisingly, other mining companies. Fuel costs are a major component of the cost of goods sold for miners, particularly bulk commodities such as iron ore and agriculture.
Three reasons oil prices will stay lower for longer
1. Supply capacity far outstrips demand.
In the 1970s when the oil price famously took off, oil producers responded by investing in more production. The result, as shown in Figure 1, was a drop in the oil price by more than 50% and a decade of sustained low prices.
A similar market cycle has just occurred. Oil demand has continued to grow, but supply has grown faster due to this investment.
Figure 1. Graph depicts the investment phases of oil since the 1900s using age in years versus oil price. Shaded areas are investment phases. 2. Shale oil technology advances.
- Figure 2 shows the dramatic impact that shale oil production has had on US and therefore global markets. US oil production rose steadily until 1971, peaking at 308m barrels per month. Then reserves were used and production fell 31% by 2007
- That was the year shale oil production technologies were being rolled out in the US. As a result, by 2015 production is back at record levels. Oil imports have consequently fallen by 26%
- Recent oil prices declines are not expected to reduce production, just drilling. US production in 2016 is expected to be in line with current levels, that is production has peaked while oil remains at these prices
- US long term reserves are estimated to be larger than the total oil reserves of Saudi Arabia. Furthermore, if extraction is feasible elsewhere in the world, total world reserves will be 10% higher
- US shale reserves have a massive advantage. They can build new production capacity in 28 days, compared to 4-5 years for conventional reserves. This will put a ceiling on prices as the US can bring on production very rapidly in response to price rises
Figure 2. Graph depicts US import versus production of oil from the 1900s and shows peaks and troughs.
3. Iran will likely re-enter supply markets in 2016.
The Iran deal won’t impact the market in 2015 but by mid-2016, if the sanctions relief is fully executed as planned, Iran could increase production by 600,000 barrels per day, taking it back to its 2004 to 2012 levels, representing 30% of global trade. This would clearly have a significant impact on prices.
There is also a floor under the current prices provided by storage and tanker capacity:
- The US has a massive surplus of refinery and tank farms, so they have little incentive to dial back production. OPEC’s attempts to push US production out of the market in a price war have failed because of this capacity to continue to store oil
- Global oil tanker capacity globally has grown by 75% in 10 years, just as the US has started its shift towards oil independence. This means that other countries with storage capacity can ship it cheaply and store it, again providing a floor under prices
Based on these arguments, the oil price is not expected to revert to the $100/barrel prices seen in 2012-2014, nor is it expected to fall significantly due to several structural floors under the market such as the storage and transport capacity, and the ability for US producers to bring more online.
Impact of lower oil prices on Australia
The benefit of falling oil prices has been counteracted by the falling Australian dollar against the US dollar – oil is priced in US dollars. This has reduced the positive impact of cheaper energy prices for Australian consumers and corporates. The oil price has nonetheless fallen, it’s just at a lower pace than the US dollar price, as shown in Figure 3.
Figure 3. Graph depicts Australian and US dollar Brent Crude pricing on oil since when the AUDUSD cross was $1 in April 2013.
Aside from energy producers and their suppliers, this is good news for equities and corporate bonds. Corporates with a large percentage of their costs linked to the oil price, like Qantas, Virgin, Rio, Fortescue, or Boral, are the largest beneficiaries. The falling Australian dollar mutes this impact, depending upon the level of hedging each company has in place.
Lower oil prices for a longer period of time contributes to lower interest rates as inflation pressure is lower, increasing the argument for longer duration positions.