From business squabble
to economic dilemma
OPEC confronts shale production while global warming threatens the oil industry
By Jean-Luc Burlone, M.Sc. Ecn., FCSI (1996)
In spite of a slowing demand growth, OPEC producers keep pumping at an increasing rate. The removal of international sanctions has enabled Iran to revamp its oil fields. The country now strives to export oil from three sources in sequence: 1) from its floating storage, i.e. oil in tankers fit to be used; 2) from existing fields that need nonetheless some restoration after 10 years of inactivity and 3) from old existing fields that require new capital investment to be operational. Iran is therefore years from reaching its old maximum level of 6 million barrels per day (bpd) and its immediate goal is more in the range of 4 million bpd. In January, it expanded its production reaching 2.99 million bpd. Not to be outdone, Iraq increased its output to a record 4.35 million bpd and Saudi Arabia boosted its own to 10.21 million bpd. In total, OPEC’s 13 members have raised their production to attain 33.1 million bpd in February 2016, while non-OPEC’s 30 producers have scaled back theirs by 0.5 million bpd according to the International Energy Agency (IEA).
The largest oil producer is determined to force high cost production such as Canadian tar sands, deepwater fields and particularly US shale production, to a halt.
Recent efforts by the Venezuelan Oil Minister to raise the price by limiting production levels have secured a conditional agreement with Russia, Saudi Arabia and Qatar, who agreed to freeze their production at January’s level. Other countries have approved the agreement with no more ado; Iran sanctioned it but remains uncommitted since it has not yet regained its market share from Saudi Arabia and Iraq, who filled in the production gap left by Iran nuclear sanctions. In fact, each country strives to preserve and augment, when feasible, its traditional market share. Adding to the ongoing squabbling, a state of distrust exists between Saudi Arabia and Russia (economic and strategic rivals in Syria) and even more so between Saudi Arabia and Iran (warring at each other by proxies in Yemen).
Low cost producers (Saudi Arabia, UAE, Kuwait, Iraq) have little incentive to reduce their production until the market price descends lower than their cost of producing an additional barrel — estimated in the vicinity of $20 a barrel. Nonetheless, all producers without exception, are hurt by low prices. Oil rich countries must refinance $400 billion in fiscal and current account deficits and over $600 billion in sovereign debt. Saudi Arabia and Russia’s financial standing is weakening as expected profits average a bare 0.5% of GDP for 2016. As a result, Saudi Arabia had its sovereign debt downrated to A-/A-2 and Russia’s credit remains under a negative outlook with a BBB-/A-3 rating, while Venezuela faces possible default on its debt payments. In spite of the financial cost, Saudi Arabia is unwavering. The largest oil producer is determined to force high cost production such as Canadian tar sands, deepwater fields and particularly US shale production, to a halt.
… concerned oil analysts demand new investment to ensure supply will be sufficient to meet a sudden demand surge whereas environmentalists are firmly opposed to further investments as being totally oblivious to the global warming challenge.
Unlike traditional oil operations, shale production facilities neither require four to five years nor large capital expenditure to be operational; they can be put in place in a month and operate like a standard manufacturing process where production can be halted or restored in a week or so. On the other hand, shale facilities have a relatively high variable cost that fluctuates between $20 and $80 a barrel, with a median cost of $50. Above the $50 mark, US shale oil production could rapidly replace any production cut by OPEC or Russia and cap any price rally. Saudi Arabia was caught off-guard by the US shale revolution. It ignored it until shale producers flooded the markets, reaching 9.4 million bpd in 2015. Surprised by their resilience — though prices fell by 70% since mid-2014 — Saudi Arabia is fiercely determined to force bankruptcy upon shale operators. Yet, shale producers have a different cost structure and some are viable at prices as low as $23 a barrel, while others weathered the storm by raising equity to reduce their debt. The rest must either cut costs, find a deep pocket partner or close their operations. Hence, Saudi Arabia’s determination is succeeding to some extent; the number of rigs drilling is plunging, 74 shale facilities (out of hundreds) are currently in financial trouble and a wave of restructuring or bankruptcies is looming. Some ripple effects are expected beyond the oil industry to regional banks, carrying the industry non-performing loans. Other markets may also be affected as — new to this oil market cycle — the financial risk is now distributed around the world by financial arrangements such as high yield debt, equity products and flexible exchange rates. In Russia as in Venezuela for instance, a flexible exchange rate allows the price of oil to remain constant or to increase in local currencies. The shock is therefore absorbed by a reduction in tax revenue, converting de facto a corporate debt into a sovereign debt.
… to survive and prosper in the low carbon environment of the coming decades, oil companies must control their CO2e emissions either by reducing it substantially or by capturing and storing it.
As it stands, the IEA estimates that supply will increase yearly by 4.1 million bpd, feeding an oversupply of 1.7 million bpd. Furthermore, and though gasoline consumption is increasing in the US, the agency expects demand growth to ease back to 1.2 million bpd. The imbalance between supply and demand therefore remains. The new oil market equilibrium will discount a persistent oversupply for 2016 and thereafter; without an OPEC supply cut and with some shale production, demand is expected to catch up with supply and price to reach the $50 mark within two years. Further down the road, the industry is facing a major dilemma; concerned oil analysts demand new investment to ensure supply will be sufficient to meet a sudden demand surge whereas environmentalists are firmly opposed to further investments as being totally oblivious to the global warming challenge.
The economic dilemma was spurred by an April 2013 study from the Grantham Institute* of the London School of Economics, which revealed that 60 to 80% of current oil, gas and coal reserves are deemed “stranded assets”, meaning that these assets cannot be burned — if the previous threshold of 2°C is to be met. (The Paris COP21’s new threshold is 1.5°C.) The study estimates that a maximum of 975 Giga metric tonnes of CO2e (the common denominator of GHG) can be emitted for a 80% probability of curbing global warming to 2°C by 2050. If, on the other hand, the currently known fossil energy reserves are consumed it would emit over 3,040 Giga metric tonnes of CO2e, enough for a 4°C global warming, with its disastrous consequences for the world economy. Yet, it is a difficult task to reduce GHG emissions by reducing consumption of fossil energy as these polluters represent 78% of the energy needed to produce and deliver $77 trillion of goods and services. In a context where global demand is expected to increase by 27% by 2035, constraining the supply of fossil energies will very significantly disrupt economic growth. The world may have to choose between two major economic downturns — caused either by the consumption of fossil energies or the lack thereof — if renewable energies remain unable to replace their fossil counterparts.
The global warming challenge may well add a partial financial crash to economic woes. The New York stock exchange is loaded with oil companies, while the London exchange favours coal companies.
Important advances have enabled renewable energy to supply 10% of the world demand — notably solar and wind technologies are increasingly replacing coal in the production of electricity. Oil is more difficult to replace, although alternative green fuel, like hydrogen, is becoming more efficient as a transportation fuel. Currently however, oil still supplies 34% of global demand, coal 23.5% and gas 19.8% while hydro electricity fills 6.5%, other renewable energies 10% and the controversial nuclear energy fills 8.5%. Hence, if the world is to succeed in curbing global warming to 1.5°C by 2050, the oil industry needs to substantially reduce its CO2e emissions either by reducing the consumption of oil or by capturing and storing its CO2e. The writing is on the wall! In January 2014, at the United Nation under the aegis of Ceres (a NPO), 500 institutional investors gathered to discuss climate warming and the uncertainty it carries for their fiduciary role. They agreed to require GHG inventories from their borrowers, to decrease funding to fossil energy companies and to increase it to selected renewable energy companies. January 15th 2014 was thus a turning date in the battle against climate warming as the big money came in line. Similarly to capital, labour adds pressure to oil companies as they have more difficulties hiring engineers than other firms because of their image as environmental delinquents. Moreover, engineers see oil as being of the past and that today’s correct engineering challenge is to figure out how to replace it. Hence, to survive and prosper in the low carbon environment of the coming decades, oil companies must control their CO2e emissions either by reducing it substantially or by capturing and storing it. Either oil becomes cleaner and remains part of the energy grid or it will be replaced by cleaner fuels.
The global warming challenge may well add a partial financial crash to economic woes. The New York stock exchange is loaded with oil companies, while the London exchange favours coal companies. Thus, both markets will see their value truncated when most of their respective energy company’s reserves will be labelled “stranded assets”. A solution that efficiently tackles GHG emissions is urgently needed for the survival and prosperity of the oil industry.
Jean-Luc Burlone, M.Sc. Ecn., FCSI (1996)
Economist – Financier
The text above is solely my opinion on the current financial context based on reports and data from the financial press. It should not be viewed as promoting an investment action of any sort.
December 2016 — JLB