Energize Weekly, March 18, 2020
The oil market is set for a long price war, falling consumption, a shake-out among U.S. shale drillers and a missed opportunity for Asian economies, according to industry analysts.
Yet even as depressed prices lead to fewer drilling rigs and a slowing in U.S. production, some operators may be in a better position to ride out the downturn and save billions of dollars in record-high hedging gains in 2020.
“The industry is well-positioned to mitigate the effects of an oil-price collapse in the short term thanks to the material cash flow support from derivative contracts,” Artem Abramov, head of shale research at Oslo-based Rystad Energy, said in a statement.
U.S. operators are already moving to cut rigs and crews and close in wells. “Shale is not dead,” Bernadette Johnson, a vice president with Austin-based Enverus, an industry analytics consultant, said in a web presentation. “The market is working the way it is supposed to.”
The market is being torqued by two trends pulling in opposite directions. A price war between Russia and Saudi Arabia is flooding the market with cheap oil, usually a spur to consumption, but the global coronavirus pandemic is pushing down demand worldwide.
On March 6, negotiations collapsed between Russia and Saudi Arabia over a Saudi proposal to cut production to bolster sagging prices. The Russians refused and the Saudis countered by starting the price war, which led to a Brent Crude spot oil price on March 16 of $33.55 a barrel.
“It wasn’t entirely surprising the Russian didn’t want to cut,” Bill Farren-Price, director of Calgary-based RS Energy Group, said in a March 12 web conference. Russia, he said, had always been more interested in production and market share than price.
“What was surprising was the Saudis launching a price war,” Farren-Price said. The Saudis had consistently sought to support prices “until they went 180 degrees in the opposite direction.”
The question is how long the battle over prices will go on. “The oil price Russia needs to balance its budget is lower than that in Saudi Arabia, meaning that the Russians can more easily weather a period of low oil prices,” Samantha Gross, an energy fellow at the Brookings Institution, wrote in a blog.
Farren-Price said that the Russian-Saudi fight is unprecedented and difficult to predict, although it is likely to go on for a while. “We are in uncharted waters,” he said. “They are creating a dynamic that creates its own momentum. I believe this will be a very difficult circle to square.”
In normal times, the sharp price drop would be a welcome boost for consumers and oil-dependent economies, but the spread of the coronavirus from China to more than 155 countries around the world has deeply depressed demand.
“China, the world’s second-largest oil consumer and biggest crude importer, is hardly in a position to benefit from cheap oil when large parts of its manufacturing sector, commercial activity and domestic as well as international travel lie crippled by weeks-long quarantines and lockdowns,” Vandana Hari, a Singapore energy analyst wrote in the Nikkei Asian Review.
Hari said that Chinese oil demand was down an estimated 2 million barrels a day – a 15 percent drop. South Korea, another Asian manufacturing hub, was the second hardest hit country in the region.
On the other side of the equation Asian oil producers – Brunei, Australia, Indonesia, and Malaysia – will suffer from declining revenues.
“The whole thing is being overturned by coronavirus,” Farren-Price said. The combination of low oil prices and coronavirus-suppressed demand will create not only economic challenges, but security issues for producers such as Iran and Iraq.
Projections for oil demand for 2020 are being sharply revised downward.
Rystad has trimmed its 2020 demand projection by 0.6 percent or 600,000 barrels a day compared with 2019.
“This is a severe downgrade compared to previous estimates and takes into account the quarantine lockdown in Italy, massive cancellations of flights by airlines, the travel ban between Europe and the U.S. that was announced … and our simulations of the virus’ growth patterns this year,” Rystad said in a statement.
The U.S. Energy Information Administration (EIA) is also projecting a 660,000 barrel a day reduction in demand and now is forecasting just a 370,000 demand increase for 2020.
S&P Platts Analytics base case has a 240,000 increase in demand for 2020, with a worst case, global epidemic scenario creating a 975,000 drop in demand.
A key target of the price war is U.S. shale oil drillers who pushed the country into first place among oil producers in 2020 with an average daily production in December of 12.93 million barrels.
This is a target at which Russia is aiming and why it is not interested in supporting prices with the Saudis. “When they cooperate with Saudis, it gives a boost to shale operations in the U.S.,” Farren-Price said.
A Wood Mackenzie analysis calculates that at current levels of activity, U.S. producers need an average price of $53 a barrel to break even, including dividends and announced stock buybacks. The spit price for West Texas Intermediate (WTI) crude on March 16 was $30.25 a barrel.
“Sustained prices below US$40 a barrel would trigger a new wave of brutal cost cutting,” Fraser McKay, head of Wood Mackenzie upstream analysis, said in a note. “Discretionary spend would be slashed, including buybacks and exploration. But given the lack of excess in the system, the cuts to development activity will be necessarily fast and brutal. U.S. tight oil development activity, though not as flexible as many believe, will react immediately.”
That quick response is precisely what many analysts say is already underway.
Enverus’ Johnson said U.S. companies are moving to cut rigs, crews and capital expenditures. The current rigs count is at 820. “In the next few months, we are probably going to growth, then you see a sharp decline,” she said.
“We are going see a lot of rigs lay down to 600 or below 600 that is going to happen” Johnson said. “If you are pulling back right now, you are betting that Russia and Saudi Arabia aren’t going to fix this quickly.”
Johnson noted that during the last price collapse in 2015-2016, the rig count dropped to 433.
U.S. production could decline by a million barrels a day, and if no new wells are drilled, there could be as much as a 45 percent decline in oil and 44 percent drop in natural gas production, she said.
The EIA is forecasting an average oil production of 13 million barrels in 2020 and then a drop to 12.7 million in 2021 – the first drop in production since 2016.
The Williston shale play in North Dakota and the Eagle Ford Shale and Permian Basin in Texas will remain “viable,” Johnson said. The rest of the shale formations will see flat to no growth.
Companies that have a large portion of their production hedged will be able to ride out the price doldrums from the middle to in some cases the end of the year depending on the hedges, Johnson said.
These companies include the Occidental Petroleum Co., Hess Corp., Concho Resources, Murphy Oil Corp. and CNX Resources Corp., according to an Enverus analysis.
Rystad Energy assessed a peer group of 30 shale operators with a combined output of about 38 percent of the total expected U.S. oil production in 2020 and concluded that the group had hedged almost 50 percent of their guided 2020 output at an average price floor of $56 per barrel.
“The peer group’s hedging gains can be as high as $10.5 billion in a $40 WTI environment, potentially rising to $17 billion if WTI averages $25 in 2020,” Rystad Energy said.
Still analysts warn that heavily leveraged operators may not be able to survive, leading to a shake-out and consolidation of drilling interests. “This might be the kind of event that might shake loose capital investment,” Johnson said.
But just as U.S. drillers can move with speed to bring down drilling and production, they have the capacity to flip on the switch when prices rebound.
“U.S. production can ramp up more quickly than other sources of oil,” Brooking’s Gross said. “Thus, any market share gains for other producers during the crisis are likely to be lost as soon as demand comes back and prices recover.”
