Commentary: Even with low prices, this is not the end of oil
Even before COVID-19 and Russia’s fall out with OPEC, the oil market was already facing a hostile landscape, says Dave Sivaprasad of Boston Consulting Group.
KUALA LUMPUR: To say that we are witnessing an era of extreme oil price volatility could be considered something of an understatement. And we may not have seen the worst of it yet.
The remarkable collapse of talks between major oil producers, Organization of the Petroleum Exporting Countries (OPEC) and Russia in March had contributed to the perfect storm, with a competitive surge in production expected at a time where the continued spread of coronavirus COVID-19 is resulting in drastic falls in oil demand. In retaliation against Russia, Saudi Arabia ramped up supply driving prices downwards as crude oil prices fell to 18-year lows.
The global landscape is so volatile that even as we write this piece, there is a niggling sense of uncertainty. It is easy to understand how low prices have fallen. It is unclear how much oversupply there will be, specifically how much demand is falling and how much supply may rise.
The withdrawal of Russia from OPEC’s agreement to slash oil supplies sent prices tumbling, with the benchmark price for Brent crude oil falling below US$30 per barrel seeming like a shocking, yet entirely feasible, guide for prices today given current movements.
TACKLING A HOSTILE LANDSCAPE FOR OIL
The initial impact of COVID-19 shaved off approximately US$20 from a barrel of oil. China, the world’s second largest consumer and biggest source of oil growth, experienced an estimated fall in demand of 400,000 barrels per day at the height of its social distancing policies. As infection rates continue to accelerate across the US, Europe and Asia, projections for where and when this demand drop might end are uncertain.
Today, the industry faces a triple shock of reduced demand, increased supply and a shortage of storage capacity to take up excess supply. All of this points to a sustained lower oil price for at least the next 12-18 months.
These remarkable shocks come at a time when oil is battling an already hostile landscape. The ongoing energy transition has gained significant momentum in recent years, with growing focus on climate action, driving greater competition for capital between renewables and the fossil fuel industry. So, is this the end for oil? Simply put — no.
While this gathering storm presents an unprecedented array of diverse challenges for oil, the fundamental demand in areas such as transport remains strong. A market report published last November estimated that the aviation industry will consume 15 per cent of the global oil demand by 2030.
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With the arrival of COVID-19, 2020 may present aviation with the most challenging year in the industry’s history, claiming several victims along the way, but there remains no commercially feasible alternative to traditional aviation fuel today. Aviation biofuel remains too expensive to be competitive.
Electric air travel would require a significant revolution in the power density of batteries. Such alternatives are unlikely to emerge rapidly over the next five to10 years.
In road transport, electric vehicles (EVs) will continue to gain traction in global markets. Yet falling oil prices may slow this transition, as lower petrol prices at the pump impact the commercial challenge of EVs. Policy measures and tax reliefs may go some way to addressing that, but ultimately result in shifting the costs from consumers to taxpayers.
While the fundamentals remain sound, there is no doubt that the extremity of current circumstances could challenge the status quo in the existing landscape.
Reports suggest Russia is prepared for a price war that sees oil prices hovering between US$25-US$30 in the mid-term. The US shale gas industry would face significant challenges under those conditions.
A QUESTION OF UNCERTAINTY IN THE US
It remains to be seen how overall US production might be impacted as events unfold. The uncertainty of COVID-19 disruption to production aside, this challenging economic landscape could result in some shale gas operators going out of business.
Yet while individual operators may face insolvency, the underlying value of their assets will remain. The likelihood is more cost-competitive operators would acquire those assets and continue production. The US oil industry has consistently demonstrated innovation in driving efficiencies and reducing costs.
That is likely to continue as long as there is profit to be made and as long as there is additional investment to be found.
There is no doubt that some US shale operators are significantly exposed during this period of drastic oil price reduction. Several highly leveraged players are at risk of not surviving a period of prolonged low oil prices.
Yet the impact across the industry will vary. Independents and mid-cap players with strong balance sheets may benefit from acquiring distressed assets at a significant discount. Major oil companies with global portfolios could look to doubling down on shale exposure as a structurally lower costing resource.
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There is another wild card on the horizon for the US shale industry of course — the question of the 2020 United States presidential election.
Not only is the impact of recent economic shocks likely to prove a contentious point within the electorate, but the question of which candidate the industry feels will most bolster them during challenging times will loom over proceedings. It may well be they commit to an existing administration that has shown abundant fondness for oil and gas.
The ultimate duration of this period of low oil prices remains uncertain. Our research suggests both Saudi Arabia and Russia can sustain a low-price landscape for a year or so. Establishing a willingness to make personal sacrifices in the name of victory could well be a bargaining chip that both players bring back to the table. The question of when parties go back to that table is another point entirely.
PLANNING AN UNCERTAIN FUTURE OF OIL
OPEC faces an uncertain future. With major producers relying on oil to balance their state budgets, the temptation may well be to supply as much as possible to maximize incoming cashflows; considering there are an estimated 6 million barrels a day of oil production currently offline in nations around the world. While this production is unlikely to come back online quickly, the race to supply could well spell an end to comprehensive OPEC cooperation, and undermine the cohesion and influence of the organization going forward.
Demand growth for oil is undoubtedly going to slow in 2020, with a likely outright year-on-year decline.
The global disruption from coronavirus COVID-19 looks likely to frame the landscape for months to come.
While this will present a turbulent period for some industry players, the fundamental demand for oil remains unshaken.
Is this the end for oil? Certainly not. But it may spell the end for reliable OPEC cooperation in the future and spark a battle for survival for established players most exposed to a period of sustained low oil prices.
Dave Sivaprasad is Managing Director and Partner of Boston Consulting Group.