Crude oil prices are currently trading at a six-year low and threatening to slide even lower as global financial markets are still trying to come to terms with Monday’s catastrophic dips. I sat down with our in-house energy specialist Peter Prazic to get the full story on how things are playing out for the oil patch.
Iyer: Peter, the question on everyone’s mind is: Why are oil prices so low?
Prazic: As cliché as it sounds, the current oil price slump really is all about an imbalance in market fundamentals. There is simply too much oil and not enough demand for it, a situation made more complicated by a variety of other economic and geopolitical issues. Oil stands at the crossroads of global affairs, and its price is sensitive to developments in almost all sectors of the economy.
Total world oil production stands at 95.66 million barrels per day (bpd), while consumption trails considerably behind it at 93.62 million bpd. That’s a lot of unused crude being stored away, which brings me to my next point. Rising global oil stockpiles are causing anxiety in markets. And while the chance of reaching an actual maximum physical capacity is highly unlikely, the psychological threat is weighing down on markets. Both OPEC and non-OPEC production levels are surging, as oil producers continue their game of seeing who can last longest.
Demand for oil is stagnating, as the ongoing stock market crisis and economic slowdown in China continues. The Middle Kingdom has really been the main driver of global demand for commodities in the last decade, oil included, and reports of slowing gross domestic product (GDP) growth and manufacturing declines have translated to shrinking demand.
There is also the jack-in-the-box factor of Iran’s return to exporting crude oil, which threatens to add an additional two to three million barrels per day to an already oversaturated market. This is complicated further by its rivalry with Saudi Arabia, the other OPEC giant, and the two countries’ ongoing proxy war in Yemen. Conflation between politics and economics is quite profound in this case.
Iyer: Who are the main players here, and how has today’s price environment affected them?
Prazic: We can broadly divide the situation into two camps; OPEC and non-OPEC. Then we can further subdivide these categories into national oil companies owned by countries, and multinational ones operating under private ownership.
National companies such as Russia’s Rosneft and Saudi Arabia’s Saudi-Aramco follow government-guided policies, which can be more politically-focused, whereas private companies act purely out of their own financial interests. National oil companies tend to be the economic backbones of their country.
OPEC continues to produce at maximum capacity, ostensibly to protect its market share and eliminate the possibility of its disastrous experience in the early 1980s, when it reduced production to raise prices and subsequently suffered a massive loss in market share. But with oil prices as low as they are, Venezuela for example is on the verge of socio-economic collapse.
Saudi Arabia, with its low oil production costs and vast reserves, along with a massive sovereign wealth fund, has fared better. Its strategy is essentially to keep producing until its competitors cry uncle. But the Saudis have a more subtle plan here. The Kingdom has approximately 70 years of oil reserves left at current production levels, and needs to do everything in its power to maintain global reliance on fossil fuels until then. An extended period of low energy prices goes a long way in reducing the momentum of renewable energy research.
As a result of falling crude prices, more and more oil majors are resorting to cutting their capital expenditures in an effort to maintain cash flow, taking on debts or selling assets to survive until prices rise. This is particularly the case with high-cost drillers involved in shale oil.
Just how bad is it? Companies such as Exxon Mobil, Chevron, Total, ENI, and BP among others are going through extreme pain, and over $180 billion in planned energy investments has been slashed from budgets, with more cuts certain to come. An index of the world’s 40 largest energy companies lost more than $40.0 billion in Monday’s carnage.
The main issue here is that oil production is a long and difficult process. As a result of the sunk costs and that stopping well production when prices are low and starting up again when they rise is financially unfeasible. Companies have no choice but to continue production. Even if you’re running in the red, meaning taking a loss on every barrel of oil sold, you’re still maintaining cash flow.
Now, with that said, there’s a great deal of public misperception regarding what production cost actually means. A cost estimate depends on if you’re doing a full-cycle analysis or simply a momentary financial snapshot, the latter of which is never completely accurate. Many production costs are locked-in long before oil prices fluctuate, and applicable taxes and other costs can and do vary during the course of a life cycle. The point is that profitability is more complicated than most media would have you believe. A similar question would be, “How much money does company X have at this moment?” to which the answer is, “That depends on how you want to measure it.”
Iyer: If oil prices are so low, why is gasoline still so expensive in the U.S.?
Prazic: That’s a good question. Because at first glance it seems that none of the price reductions in crude have been passed along to the consumer. What you have to remember here is that between oil being pumped out of the ground and your average person pumping gasoline into their car is an entire value chain of separate businesses and logistical systems. Each of these is impacted by a variety of factors, and shifts in the upstream oil sector often do not translate as intuitively as you might think by the time you’re refining the oil into gasoline and distributing it to end-consumers. Gasoline prices are largely subject to local pressures such as ease of transportation, local supply and demand, and applicable taxes, among other factors. Pipeline and refining capacity comes into play here, because crude oil can’t be instantly transported across the continent to where it is needed, and refineries often can’t keep up with spiking demand.
The bottom line, however, is that downstream gasoline distributors have no incentive to pass along savings to end-consumers. Gasoline is a relatively inelastic good. And a widening profit margin is no cause to reduce its price.
Iyer: Would you say this is a good time to invest in energy stocks?
Prazic: I can’t say this is the ideal time to go bottom-feeding. That being said, there are still plenty of undervalued stocks to be found, and a savvy investor stands to make a good profit if they know where to look. If you’re no stranger to risk, I would recommend looking at oil and gas companies with a solid financial position and low debt levels.
Iyer: What can we expect from oil prices for the remainder of this year, and into 2016?
Prazic: The near-term is anyone’s guess, given the volatility we’re seeing in financial markets. I can’t see where any uplift for oil will come from. With rising global oil production, oversupply, surging oil storage levels, and stagnating demand, this latest nightmare across major global indices couldn’t have come at a less favorable time for oil. The fact of the matter is that with summer driving demand about to end and refinery maintenance season starting up, prices still have lower to go.
We haven’t seen the bottom yet, and I wouldn’t be surprised if we see oil prices hit the low $30.00s, and perhaps even the $20.00s by the end of 2015. Barring a surprise end to negotiations with Iran, which is somewhat possible if we are to believe the latest noise coming from opposition to the deal in Washington, downward price pressure will continue until demand is forecasted to grow by mid-2016.
In a long-term scenario, the extreme slowdown and round of cuts this year to exploration and production by oil majors will eventually translate to less oil supply in the future. It’s simple math, really. Because so many energy projects have been slowed down, paused, or outright cancelled, we will eventually see a dip in available crude oil. This will then cause prices to swell. It won’t be clear when this phase does begin, but it eventually will.
Iyer: Peter, thanks so much for setting aside the time for this interview.
Prazic: My pleasure, Gaurav.