An Energy Outlook for 2016

Oil gas processing plant with pipe line valves
J. F. Reader & S. A. Reader, Barchan Advisory Services Ltd. ©

At the end of a year one can either consider the year just past or purport to forecast the year ahead.  As far as the energy industry goes, 2015 did not have much to recommend it.

Prices plummeted in January, and then after pretending to perk up in June, performed a series of ‘dead cat bounces’ right to the year-end.  US$ WTI entered the year in the high $40’s and exited the year in the high $30’s, averaging approximately $49/bbl for the year.  Every other price benchmark, whether international or domestic, oil, gas or liquids has averaged about half of its value in 2015 when compared to 2014, and the year-end trending is even worse.

Where the prices go, so goes every other aspect of the industry.  Barchan commented on the steps taken by experienced management teams back in January, and we are sorry to see that the predictions then came about in spades.  Employment is way down as capital budgets have been slashed at least twice, and operating costs are under extreme pressure.  Rig counts in North America, the true free market in the global oil business, have dropped by two thirds, service companies are on the ropes, and the negative trends continue.

For investors, stock prices have collapsed and dividends have been cut or eliminated.  Only the super-major companies have held their ground, but dividend yields are rising reflecting the perceived risk of these largest of public energy companies.  In addition, there have been bankruptcies and the restructuring of debt.

So, with this rather dreary micro-look back, Barchan is going to step out on a limb and give its view of what will happen in 2016 to the industry we love.  We choose to be bold in our predictions, because people will remember them if they turn out to be correct!

Whence Commodity Prices?

Supply
Every time there has been a sharp rise in oil or gas prices it has been followed by an extended downturn.  The reason is simple.  High prices not only drive the use of conventional methods to increase supply, but they provide the cash influx to develop new technologies that unlock new resources. The industry’s latest renaissance is the use of extended horizontal wells and the scaling up of an old technology – hydraulic fracture stimulation.

Both these methods have been dramatically improved by rig and borehole mechanical technology improvements.  Rigs have become automated, top-drive and AC-power equipped, and more mobile.  Sliding sleeve and other selective zone stimulation methods have revolutionized the production enhancements available for use in tight reservoir conditions.  These new applications have allowed the production of previously uninteresting zones with inaccessible hydrocarbons.  The effect on North American production has been dramatic – a complete reversal of continental production decline to the tune of about five million barrels per day of liquids and oil.

Further to the enhancement of technology, the ten-year up trend in prices was sufficient to spur on certain global-scale mega-projects such as the Canadian oil sands, and Northwest Australian LNG, just to name two.  These projects, because of their long lead times and sheer capital scale only come about when prices stay high for extended periods.  Then they get commissioned and operate for lifetimes measured in multiple decades.

Elsewhere, various OPEC and other nations that rely almost exclusively on their oil and gas revenues to prop up troubled or corrupt regimes, have become fearful of losing their influential positions as swing suppliers.  Saudi Arabia in particular has had enough of being the disciplinarian of OPEC and has consciously chosen to not curtail, and perhaps even increase its production.  Not even prices that have fallen below the cost of production replacement have been sufficient to change this policy.  It is clear that even the Saudi’s did not expect the prices to plummet as they have.

Demand
Globally, demand has been remarkably robust. Each year that goes by seems to result in a demand increase of between half and one million barrels per day.  Growing Chinese, Japanese and South Korean economies also drive LNG demand increases.  Despite fear mongering in the media, the world’s emerging economic giants are not stalling out.  Should the average economist actually worry if Chinese GDP growth falls below 12% to 7%?

At the same time there is growing pressure to curtail the burning of coal because of the relative carbon inefficiency and particulate and heavy metal-rich flue gases emitted by coal-fired power generation.  This societal pressure is not just in North America and Europe, but also in China, where Beijing is routinely blanketed in killing smog.  All this is to suggest that the demand growth for oil and gas worldwide is not tapering off any time soon.

Inventory and Storage
As Barchan pointed out in an earlier article this year, the supply and demand price signal is clouded by a number of things and in particular storage.  Global storage is hard to measure because it occurs in some subtle forms.  Tank volumes are reasonably accurate to measure, but they can get confused between raw and refined product.  Ship-borne inventory is more difficult to measure, and it is always a good finance media story to talk about ships loaded with product drifting at anchor with nowhere to go, or ships being turned away from port or diverted mid-ocean due to oversupply.  Barchan thinks these stories are mostly ephemeral in nature, and not fundamental to a yearlong forecast.

However, there is one type of storage that is impactful and we will freely admit was underestimated by our group over the last two years.  This is the inventory that has yet to be produced from a reservoir.  In an efficient capital market, once the investment in drilling is made, it should be in the producers’ best interests to get that production on-line immediately and to start generating a cash return.  To fail to do so reduces the net present value of reserves, especially when the forward price curve is flat to declining.

North American producers however, have not been acting prudently in the best interests of their shareholders and so a large inefficiency has developed that has formed an inventory of unknown volume.  Thousands of very expensive wells have been drilled in 2014/15 to create a ‘fraclog’ of drilled, but uncompleted reserves.  The actual size of this inventory has been impossible to accurately assess, both because the number of standing wells is not easily determined, but also because the productivity of those wells cannot be understood until they are completed and produced.

This market distortion has come about due to a lack of capital discipline in the industry, the need to preserve land positions, and made possible by a failure of investors and other capital providers to hold executives accountable for rates of return that are compromised by these practices.  Regardless, the effect has been to provide a tremendous backlog of half-cycle economic completions that can be justified in a low price environment even when the full-cycle projects would not be justified.  This just slows down the producer response to low prices induced by temporary oversupply.

Gas inventory in North America faces many of the same challenges as oil.  For years, midstream players have attempted to play the seasonal demand cycle by creating large underground storage facilities.  These facilities now have a theoretical volume exceeding 4 TCF, but the winter demand cycle just has not succeeded in lowering these stored volumes sufficiently to provide for any appreciable price recovery from today.  Furthermore, the associated gas produced with the oil in most of the main unconventional reservoir plays across the continent complicates the situation.

Price Prediction for 2016 and Beyond
Barchan is calling for an average price of US$40/bbl WTI for 2016 that will equate to a C$52/bbl light oil price in Edmonton.  It will not be surprising to see oil drop to below US$30/bbl WTI in the first half of the year as rumours of large tranches of Middle Eastern oil additions (Iran, for example) and Russian increases are promoted by speculators, or if there is an indication that Cushing storage in Oklahoma might approach capacity.  Large speculative short positions could temporarily distort the market price under these circumstances in the first half.

Expect Brent to stay at a very narrow basis differential to WTI, perhaps within US$2/bbl.  Our view is that ultimately WTI will settle to a price at the marginal barrel cost (that is, the most expensive economic barrel) and that this barrel is from one of the US tight reservoir plays – potentially the Permian, but more likely, the Eagleford or Bakken.  It is difficult to determine what this cost is, but we will guess that it is around US$70/bbl and would expect to see a recovery to this level towards the end of 2017, leading to an average 2017 price of US$60/bbl WTI.  At these prices there will be no new oil sands projects sanctioned in Canada.

Natural gas is not dominated by a single global price standard due to its more challenging transportation issues.  In North America, we will call for Henry Hub to average US$2.50/mmbtu for the next two years, and for the Canadian AECO Hub to be C$2.00/GJ.  LNG contracts are typically long term and project specific, and although these contracts are showing some signs of change, they have a heavy tendency to be benchmarked against oil.  Rather than make a price prediction, Barchan suggests that there will be no North American LNG projects, not already under construction, that will be sanctioned or commissioned in the next two years and probably not in the next 5 years.

Concluding Remarks

Barchan’s price forecast points to a significant adjustment to the petroleum industry that will have a longer duration than previously expected, and that will extend the pain felt by industry players, cause significant changes in industry capital and cost strategies, and will ultimately reduce the number of companies in the sector.  In a subsequent article, we will address some of the collateral trends that are developing as a result of these low commodity prices.


Copyright © Barchan Advisory Services Ltd. 2016

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