Energy Markets: Oil & Gas In A Lower Price Environment

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This story was published on July 16 for subscribers and has now been opened for general readership.

By Greg Peel

After over a decade of negotiation, this week saw a deal being struck between Iran and a group of six countries – the US, UK, Germany, France, Russia and China – that will see economic sanctions placed on Iran by the US, EU and UN ultimately lifted. In exchange, Iran will cease to pursue any ambition to build a nuclear weapon.

For the last few weeks, expectations of a deal being finally struck have intensified as the US has extended Iran’s compliance deadline time and time again. While ongoing extensions suggested the two parties remained at odds, financial markets saw the increasing brevity of extension periods as suggesting agreement was not too far away.

To that end, oil prices broke back down through the trading range established over May and June in which West Texas crude managed to hover around the US$60/bbl mark, following a rebound from the perilous drop that began last year. Oil markets also had their eyes on Greece and China, as were the focus of all other markets, but for oil the Iran negotiations were of primary importance. The lifting of sanctions means Iranian oil exports can flow once more.

While Iranians would this week be feeling much relieved, the timing of the agreement could not be a lot worse in terms of the current state of the global oil market. US producers have been forced to shut down oil rigs to reduce global oversupply now Saudi Arabia has broken with decades of OPEC-controlled pricing and is producing and selling as much oil as it can at whatever price it can achieve. Now Iran, requiring a rapid catch-up to restore its crippled economy, will also let loose with its own indiscriminate sales.

One might have expected oil prices to collapse once again on the announcement an Iranian deal has been reached but this was not the case, with West Texas and Brent actually posting small gains for the session immediately following. The reason prices did not fall is twofold: (1), prices had already fallen in anticipation that a deal was near and (2), any notable increase in Iranian oil exports is still at least six months off.

There remains opposition to the agreement in the UN – notably Israel – and in the US Congress, albeit in the latter case President Obama has already indicated he would veto any move to derail the deal if possible. Iran does have supplies stored offshore in tankers ready to be sold immediately but volumes are not large in the scheme of things, and there is no guarantee buyers will be quickly found.

Iran has suggested it can restore a previous level of one million barrels per day of sanctioned oil exports in reasonable time, potentially raising output by 400kbpd in the first month and the remaining 600kbpd by the end of six months, but oil analysts consider such a time scale to be optimistic.

Moreover, and irrespective of political processes to be completed, this week’s announcement does not yet give Iran the green light. The starting point of the deal is for Iran to allow access to the International Atomic Energy Agency for confirmation of the reduction in centrifuges in the country and for the establishment of a workable, ongoing monitoring system. This process will take time, thus the oil analysts at Citi do not expect a green light to be given to Iran within six months.

Only then can oil exports resume, but here Citi is sceptical of Iran’s expectations as well. Given the complexities of the Iranian oil fields, Citi does not believe production could increase by 300kbpd without foreign help. Ramp-up to 300kbpd would then take three to four months, and another 200kpd could be added within six months or so. In other words, consensus suggests Iran’s own target is double that of reality in a shorter time frame.

One issue is that if Iran did try to ramp up production at a rapid pace, there would be an elevated risk of well damage and potential to send production back into decline for the next six to twelve months. Another issue is that while ramping up is all well and good, Iran still needs someone to actually buy the oil, and the market is already oversupplied. This suggests a risk Iran might dump oil at any price, sending global oil prices crashing once more, but if Iran cannot re-establish its production without the assistance of foreign oil companies, those companies are not going to provide financing to support dumping.

New paradigm

If Saudi Arabia thought its decision late last year not to enact OPEC production cuts in the face of falling oil prices, as it had always done, would mean short term pain for longer term gain, that short term just keeps getting longer and longer. While it was fair enough that the responsibility of production cuts should fall upon North American producers who were responsible for global oversupply in the first place, any expectation shale oil production would be halted has proven misguided.

While shale oil production is indeed high-cost, and the highest cost US rigs were indeed quickly shut down as soon as OPEC made its surprise decision, the result has not been a return to oil prices to around the US$85/bbl mark that Saudi Arabia has long considered to represent a reasonable equilibrium. The problem for OPEC is that the big surge in US shale production is the result of constantly improving technology. That technology has brought down, and is continuing to bring down, the cost of production.

This means that while oil fell below the breakeven price for many a US rig in the first half of 2015, at the same time that breakeven price has also been quietly falling. This month the US rig count actually rose in a week, representing the first increase for the year. Once the West Texas price had bounced back to around the US$60 mark, some of the idled US rigs again became profitable.

This now suggests US$60/bbl for West Texas (US$65 for Brent) is the likely near term cap in the oil price. Equilibrium of US$85/bbl is a very distant goal. Over six months after the Saudis made their decision, the government has now been forced to borrow money. Petrodollars no longer cover the cost of supporting the kingdom. For that, the Saudis cannot blame North American oil production.

Will OPEC now be forced to cut production quotas to restore prices? The question here is that if Saudi Arabia were to relent and go down that path, would OPEC members fall into line? Iran is hardly likely to cut production it doesn’t even yet have. Iraq has a war to fight, Nigeria is in a similar boat, Venezuela is broke, and Libya, for one, does not really have a government. Were Saudi Arabia to cut production it might find itself standing alone, in which case the void would be quickly filled and there would be no price relief forthcoming anyway.

UBS sees little or no likelihood of OPEC agreeing to cut production but sees Iran as offering the only real risk of any magnitude of supply upside. Meanwhile, “structural cost deflation”, meaning the falling cost of oil production both through technology and other factors (including, ironically, the cost of energy), of a scale more significant than expected provides the key downside risk to UBS’ medium term oil price forecasts.

Macquarie does not expect any supply response from OPEC members either, nor from Russia, which is another significant global producer smarting from lower oil prices at a time of economic sanctions. Despite growth in US production potentially slowing to zero, Macquarie remains bearish the oil price in the near term.

Global Demand

This week saw a surprise fall in June US retail sales when lower oil prices were expected to boost US consumer spending and assist a rebound in GDP out of another snowbound March quarter. Yet while US consumers may not be rushing out to blow the savings they are making on fuel costs, they are responding to lower oil prices by increasing the consumption of gasoline.

As the US economy continues to improve, a real improvement is being seen in US gasoline demand, Citi notes. Such improvement has been tendered in evidence by those who have long suggested lower oil prices would boost the demand for oil across the globe, meaning prices would indeed soon rise back to an equilibrium level below the triple digits of old but well above the lows seen early in 2015. However, this appears not to be proving the case.

As at last month, emerging May data indicated that all of China, India, France and Italy, at the least, were seeing no positive response in oil demand. The US is not a good global benchmark in this instance, Citi notes, given its improving economy, lower tax on gasoline and lack of currency drag on lower US dollar-denominated oil prices.

LNG Impact

The surge in US shale oil production has coincided with a surge in shale gas production, to the point the US is in the process of switching from an importer of LNG to an exporter. A wave of US LNG projects is coming, Citi notes, and a year ago their competitive prospects looked enviable.

They looked enviable because the price of gas in the US has never recovered from the GFC. The price of oil collapsed below to US40/bbl after the GFC, but soon began a recovery that took it solidly back to prices above US$100 on the back of QE, Chinese growth and geopolitical tensions. The price of US gas also collapsed after the GFC, but given US gas is produced and consumed entirely within the US, its price remains today at a similar level.

This puts the US in a very competitive position within the global LNG export market it is soon to enter. LNG export cargoes are priced globally on an indexed basis to the oil price. Thus as oil prices rise and fall, LNG export prices rise and fall. Were the US ready to export LNG a year ago, producers would have been able to charge a much lower price for exports, linked not to an oil-indexed price but to the US domestic gas price (Henry Hub). In short, the US posed a real threat to global LNG producers and soon-to-be-producers, most of which are in Australia.

But a year ago, the oil price was above US$100/bbl. As oil prices have fallen, so has the gap closed between oil-indexed and Henry Hub-indexed pricing. A Brent price of US$62/bbl implies a Pacific Basin LNG price of US$8.9mmbtu, Citi notes. At current Henry Hub pricing, hypothetical exports from the US would be priced in Asia at between US$8 and US$9mmbtu.

And if the US were an exporter today, it would also suffer a freight cost disadvantage. The distance to China from Western Australia is less than the distance from the US Pacific coast, but the bulk of US LNG capacity is located in the Gulf of Mexico anyway. Today’s gas supertankers simply cannot squeeze through the hundred year-old Panama Canal, so they have to go the long way around.

On that basis, if US LNG was ready for export today it may not be sufficiently competitive. The good news for US producers is that the Panama Canal widening project is due for completion in 2016. Meanwhile, there are also plans for LNG facilities to be constructed on the Pacific coast.

That said, Citi believes the outlook for global LNG markets is weak until 2022-23. Chinese buyers have over-contracted, the broker suggests, Korean LNG demand is in decline thanks to the start-up of new coal and nuclear powered electricity generation, and the first Japanese reactors are soon to restart.

Domestic Gas

Aforementioned technology improvements have also made their mark in Australia’s Cooper Basin. Technology, improving markets for gas and operators focused on organic and M&A growth have driven the Cooper’s re-emergence from a long-term decline, Morgan Stanley notes.

The Cooper currently supplies around 20% of the Australian east coast gas market and has the capacity to supply a lot more, Morgan Stanley suggests, given enormous resources yet to be unlocked. The Cooper Basin is unique in being connected via pipeline to all major demand centres in eastern Australia, providing for multiple commercialisation options. As an onshore conventional gas resource, the Cooper is low-cost.

The broker recently upgraded Cooper operator Beach Energy ((BPT)) to Overweight on this basis. Among other operators, Morgan Stanley has an Overweight on Senex Energy ((SXY)) and an Equal-weight on Drillsearch Energy ((DLS)).

Citi sees a growing supply shortage of domestic gas versus forecast demand from 2020-24, depending on the level of Cooper Basin and Queensland coal seam gas reserves, the cost of developing CSG reserves and the level of new CSG capacity sanctioned over the medium term. The broker sees the winners from this demand/supply forecast as being the integrated portfolio players, specifically CSG big boys Santos ((STO)) and Origin Energy ((ORG)).

Unfortunately Citi does not entirely agree with Morgan Stanley on the Cooper juniors. Companies with high-cost, high-risk gas resources are unlikely to be developed in scale for some time, Citi believes, hence the broker has a Sell rating on beach Energy, while maintaining a Buy on Senex Energy.

Macquarie has also recently upgraded Senex to Outperform given the fall in stock price. Seven FNArena database brokers cover Senex, for a Buy/Hold/Sell split of 4/3/0. Morgan Stanley is otherwise the only FNArena broker with a Buy or equivalent rating on Beach Energy, which otherwise attracts two Holds and four Sells.

Outside of the Cooper, Macquarie’s junior preferences are AWE Ltd ((AWE)) and Sino Gas & Energy ((SEH)). Among the big global players, Oil Search ((OSH)) remains Macquarie’s key pick, given the market does not ascribe sufficient value to PNG growth options in the broker’s view. The broker also believes concern over Santos’ geared balance sheet will be alleviated later this year with the timely delivery of GLNG.

On the same argument, UBS has Santos as its key pick, and the broker acknowledges Oil Search’s positive growth prospects.
 

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