Tom Nelson, head of commodities and resources at Investec Asset Management, shares his outlook for oil after the latest OPEC meeting.
What now for OPEC?
The June 2015 Organisation of the Petroleum Exporting Countries (OPEC) meeting concluded as expected with no change to the 30 mb/d OPEC production “ceiling”. In reality this appears to have been an uneventful meeting, with much self-congratulatory rhetoric and a clear view of a crude market that is currently well-supplied, though with slowing non-OPEC production and better demand.
OPEC is now struggling for credibility. The organisation was forced into Plan B last November when no country was prepared to join the Saudis in a production cut. OPEC continues to maintain the 30 mb/d production target, but has been producing up to 31.5 mb/d, with all members maximising production.
We now have an OPEC without any immediate productive spare capacity, no intention of cutting production, and a production target that is not being adhered to. We should therefore ask whether the cartel has any relevance? The answer should be “no”, unless there is an expectation of the cartel reasserting market influence in future.
Unfortunately, OPEC members show no intention of addressing the difficult questions. It appears that there was no specific discussion of how production may be curtailed either to bring it back in-line with the OPEC target or to accommodate incremental Iranian production when sanctions are lifted. We should remember that any change in OPEC targets or policy needs unanimous approval from the 12 full members. Given the building animosity between the Gulf members we do not see any change of policy at the next meeting (in December).
While the lack of clear policy continues to extend the market confusion, it is noteworthy that OPEC’s view of the supply/demand balance has changed. The November statement referred to a “projected increase of 1.36 million barrels per day in non-OPEC supply in 2015”.
Friday’s release referred to 700,000 barrels per day of growth. They also noted that “the sharp decline in oil prices witnessed at the end of last year and the start of this year – caused by oversupply and speculation – had now abated”. More telling, perhaps, is the change in Al-Naimi’s language: “the future looks positive” and “you can see that I’m not stressed, I’m happy”, a far cry from the belligerent statements made in late 2014. The market is balancing itself and the plan is working.
Outlook: Brent will increase to US$80 by year-end
With no expectation of market moderation from OPEC, crude will price on perceived fundamentals. This will lead to a continuation of the more volatile pricing that we have seen over the last seven months, as we outlined in our 28 November note: “OPEC meeting – the morning after”.
The consensus is that the market will be balanced in the next few years by unconventional (fracked) production from the United States. The main debate is centred on the US:
– how significantly will production and inventories correct following the 60% rig count reduction;
– how many rigs will be required in 2016; and
– what crude price is needed to incentivise and sustain this rig count?
We believe this viewpoint is too narrow. There is little account being taken of the effect of low oil prices on the rest of non-OPEC, as well as OPEC production. Similarly, the agencies have been slow to reflect the strong demand that is evident, stimulated by lower prices. The same commentators that called for oil prices to revisit January lows in Q2 are now making the same calls for Q3 and Q4 and some are calling for oil prices to remain under pressure until 2020.
Our modelling (which has correctly predicted the price recovery for Q1 and Q2) shows the market tightening quickly through the second half of the year. We forecast in January that Brent would average $60/barrel in Q1 and $65/barrel in Q2. In reality, Q1 average was $55/barrel and Q2 average is $63/barrel so far.
We expect Brent to move higher from here to reach $80 by the end of the year, giving a full-year average of $70/barrel. This puts us 15-20% above most sell-side analysts.
US shale: rig count falling
While we agree that the crude market will indeed be balanced by incremental US production in 2016, we believe that the US unconventional producers will require a price consistently above $70/barrel to increase activity and production. We model that the US rig count needs to increase by as many as 400 rigs by the end of 2016, which will only happen in a significantly higher price environment than we have today.
We note that the US rig count continues to fall. There are considerable complexities in modelling the US unconventional production from here, as many have identified. The competing forces of decline rates, well productivity, improving rig efficiency and lower costs make the economics very changeable, but one thing remains relatively constant: the relationship between cash flow and capex within the US Exploration and Production group.
Price and labour market concerns
We do not believe that a $60 oil world will generate enough cash flow for these producers to increase spending and production. We have observed the considerable optimisation or increased rig efficiency in the short term, but still believe that the market is too optimistic about US shale oil economics.
We also have a concern about the labour market: the oil industry is losing key operational staff at a period of nearing full employment in the United States. It will be very difficult to attract personnel back to the industry, therefore service pricing is likely to tighten quickly, particularly onshore in the United States, when the industry goes scrambling for incremental production.
Cuts to capex
Costs have reduced very quickly in response to the dramatic reduction in activity. This is good for the producers, and also for the industry that had become increasingly inefficient with deteriorating returns on investment. The problem now is the high level of uncertainty: without a guideline target price from OPEC, the industry will struggle to take investment decisions and access sufficient funding.
We have seen this in the deferral of projects and the large cuts to capex budgets: we estimate that US onshore capex will fall approximately 40% year-on-year (2015 on 2014) and that global upstream spending will fall approximately 20%. In an industry which has struggled to grow production outside US shale – despite a 15% annualised spending growth rate since 2003 – this cut to investment is likely to be very damaging.
We would like to emphasise one final point on supply and production capacity: unlike in previous downturns, there is no large tranche of spare production sitting on the sideline. In 1985, for instance, the market was 15% oversupplied. We believe that OPEC is currently fully extended, as evident from the Saudi refusal to make further volumes available to the Chinese through this summer.
We forecast in late November that this period of lower prices would stimulate increased demand for oil on a global basis after a sluggish year in 2014 and so it has proved. It has not been restricted to the non-OECD world: US demand has continued to exceed expectations, and Europe has also been better.
Seasonally we would expect demand to be 1.5 mb/d stronger in the second half of the year, and we do not expect any assistance from significant incremental Iranian and Libyan volumes in this time frame.