More On The Outlook For Oil And Gas Prices

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By Greg Peel

See previous: The Outlook For Oil And Gas Prices

Last night the price of Brent crude – the global oil export benchmark – fell to its lowest level since June 2012. Last night’s fall was triggered specifically by an IMF downgrade to global economic growth forecasts, but the IMF is only catching up on what everyone already knew: the eurozone is likely heading into recession, Chinese growth is slowing, and Japan is struggling to generate the kind of growth expected from the depreciation of the yen.

Only the US is showing signs of life among the large economies, but it is the US providing the problem on the supply-side rather than the demand-side with regard oil prices. US domestic oil production is soaring, and at the same time US transport infrastructure is gradually being switched around from an energy import configuration to a domestic energy consumption and growing export configuration. Presently the US cannot export crude at will due to government restrictions, but it can export oil products such as gasoline and diesel.

The surge in US shale oil production has thrown OPEC out of kilter, given the producer bloc no longer enjoys the supply-side dominance it once did when the US was reliant on oil imports, and hence has lost a level of its price control power. OPEC is currently selling cargoes at a discount to clear building inventories, ahead of expected production quota cuts by the end of the year. Once upon a time OPEC could ensure a floor under global oil prices by tweaking production volumes, but with North America rapidly becoming “the new OPEC” (US, Canada, Mexico), the ability of the old OPEC to achieve a floor is less certain.

US shale oil production is nevertheless a costly business. Indeed, if the US benchmark price of oil, West Texas Intermediate, falls much further those shale oil producers at the high end of the cost curve will become uncommercial and begin to cut production. Combine this with assumed OPEC production cuts, and global oil prices should find a point of stability, even if global growth forecasts fall further.

And it is not beyond the realms of possibility Saudi Arabia, as OPEC’s leader, adopts a “you broke it, you fix it” attitude with the US, as Credit Suisse analysts ponder. Were OPEC not to cut production and instead let prices fall, this could result in a lot of US production being forced to shut down.

Of course underlying all of this is the benefit to the global economy of a lower cost of energy. Lower oil should help slow the rate of global slowing. All, thus, works towards some kind of equilibrium.

That said, we must not forget that many oil producing nations are among the current list of geopolitical hot spots – Iraq, Libya, Nigeria and to a lesser degree Venezuela, as Credit Suisse points out. Supply disruptions are always a threat.

The surge in North American oil production has not just thrown OPEC out of kilter. Not all US oil imports come from enemies. Now that the pipeline running from the major US refinery centre on the Gulf to the major US storage centre at Cushing in the US mid-west has been reversed, US shale oil and Canadian oils can be refined for domestic benefit rather than locked up in tanks at Cushing (which is why the Brent-WTI spread has come in from US$27 to around US$5, more realistically reflecting transport costs). This means the Gulf refineries are importing less crude, not just from the Middle East but from West Africa and Gulf of Mexico producers as well. The whole equation is affecting dislocation and imbalance among global oil exporters and importers.

The export of US crude is restricted by regulation but not completely banned. Thus last month saw the first cargo of Alaskan North Slope crude in a decade set off for South Korea. This tanker is the first in what Citi analysts suggest will now “become an armada”. Meanwhile, way down in the Gulf, refiners will likely invest in upgrading their capacity in order to increase exports of oil products.

US shale production is thus not simply having an impact on US domestic oil prices, but on global oil prices through lower US import demand and rising US crude/product exports. The price of Brent fell 10% in the September quarter. Citi has revised down its December quarter average Brent forecast price to US$100.00/bbl from US$109.30/bbl, and its 2015 average price to US$97.50/bbl from US$105.00/bbl. Citi nevertheless expects a near-term rebound in oil prices as we enter the peak of global refinery maintenance shutdown season.

And as Deutsche Bank notes, the December quarter also brings a seasonal increase in demand for the northern winter. Deutsche also points to the aforementioned self-correction mechanism of US shale oil production, were prices to remain low, and to likely OPEC production cuts in forecasting a December quarter average Brent price of US$103.00/bbl.

So what does it all mean for Australian oil prices? Not much, given the Aussie dollar has begun to revert to its historical “commodity currency” status and away from its more recent “safe yield” status under threat of rising US interest rates, meaning the fall in the Aussie coincident with the fall in the Brent price (via Tapis) has kept “prices at the pump” relatively stable.

What is of more concern to Australian energy companies is the implication of lower global oil prices with regard LNG pricing, just as the enormous step-jump in LNG exports is about to become a reality.

JP Morgan’s analysts had become concerned that the apparent slowdown in global growth implied this year’s seasonal northern summer drop-off in demand would not prove simply seasonally at all. But having toured China, South Korea and Japan to assess such a possibility, the analysts have come away with a different view. “Not only did our tour confirm that demand remains robust,” they reported, “the LNG spot market is likely to remain illiquid with high price volatility, and not at all representative of future LNG supply/demand fundamentals, as Asian buyers continue to prefer long-term contracts (still mostly oil [price]-linked) and the new LNG hubs seem to be a very early work in progress”.

In other words, Asian countries still have a preference for security over price, in that they will pay a premium for longer term delivery contracts rather than risk playing the spot market. This suits Australia’s LNG export hopefuls, given the economics of costly LNG facilities also rely on price security.

The first new LNG export cabs off the rank, following on from the start-up of PNG LNG a few months ago, will be the Queensland CSG LNG facilities. And this fraternity has suffered a bit of a scare of late.

LNG facilities take a long time and a lot of money to build, and throughout the decade-long construction process no one has been hugely surprised by ongoing delays and cost overruns. But more recently, as start-up dates have become more clear, progress has sped up somewhat. The problem is, part of the process is to make sure there’s plenty of coal seam gas ready for conversion. As the plants are not yet ready, that CSG has been diverted into the Queensland domestic gas market, causing a supply glut and tumbling prices.

So much so that BG, operator of Queensland Curtis LNG project which was due for start-up possibly later this year, has elected to delay. Were this to be a structural, rather than temporary, issue, the delay would have serious implications for Origin Energy’s ((ORG)) nearby Asia Pacific LNG project and Santos’ ((STO)) Gladstone LNG project. But it all “needs to be put into perspective,” suggests Morgan Stanley.

“This phenomenon is temporary,” says MS. “When the various LNG trains are commissioned from year end, gas from CSG wells will be directed away from the domestic market. If the LNG plants require more [gas] than field availability, then the market will tighten and spot prices could soar for example”.

So investors in Australia’s Queensland LNG aspirants need not panic.

Table 1 below provides forecast data for Australia's major listed energy companies. Table 2 outlines LNG project timetables.

Table 1.

Table 2.

 

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