Growing evidence of a global recession continues to take a heavy toll on the oil business.
The International Energy Agency (IEA) and the World Bank are forecasting the first decline in economic growth in 25 years, with a consequent decline in oil demand.
Until recently it seemed to most analysts (including myself) that the red-hot economies of the developing world, particularly China, would more than compensate for the reduced consumption of oil in the US and Europe. A stream of bad news reflecting a sharply slowing global economy now suggests otherwise.
OPEC President Chakib Khelil believes that the global recession could slash 1.4 million barrels per day (mbpd) of demand in the first half of 2009, as China’s economic growth rate fell from 12% to 9% in the third quarter, the slowest pace in five years. China’s steel output in October fell 17% year over year. The country has ceased gasoline imports altogether, and cut its diesel imports in half. Reports of factories closing continue to come out.
Industrial production in Russia, Brazil, and other resource plays has likewise plunged along with global demand for basic materials like fertilizers and steel.
Accordingly, a slew of financial forecasters have downwardly revised their oil price targets. Merrill Lynch analyst Francisco Blanch, who correctly predicted that oil would spike to the $147 region this year, slashed his forecast to $25 for 2009 if the global contagion extended to China.
Analysts at Goldman Sachs predicted $30 oil in the first quarter of 2009, and a Deutsche Bank analyst cut his estimate to $47.50 for 2009.
OPEC isn’t going to take the price collapse lying down. The group’s members need at least $70-$80 a barrel to sustain investment and meet budgetary needs, according to Khelil.
In an effort to support prices, the cartel announced today a new 2.2 mbpd cut in its production targets, in addition to the 2 mbpd of cuts already announced. The latest reduction—the third in three months—brings production targets 4.2 mbpd, or 9%, lower than September’s levels. According to Saudi oil minister Ali al-Naimi, Saudi Arabia has already cut 1,200,000 barrels per day from its output since August, and the rest of OPEC has cut its production by 500,000 barrels per day.
Even that may not be enough to stem the decline, however, so they have been vigorously lobbying Russia, the world’s top oil producer, to cut its output by 500,000 barrels per day as well. At the OPEC meeting today, Russia signaled that it would make a 320,000 barrel per day cut next year if prices remain low. That is in addition to the 350,000 barrel per day cut it made in November. The nation is also reportedly considering joining OPEC.
IEA Squirms, and Warns
An interesting sidebar to the OPEC action was an interview published in the Guardian earlier this week, in which journalist George Monbiot grilled IEA chief economist Fatih Birol about the agency’s most recent oil outlook. (See also my critique of the report, "IEA Oil Report: ‘Time is Running Out’.") He wanted to know why IEA was now implying a peak/plateau around 2020, when the agency’s previous Executive Director Claude Mandil had maligned peak oil theorists as "doomsayers" in 2005. Birol professed ignorance of the previous executive director’s statements, and deferred the question to the current executive director, Nobuo Tanaka.
Since IEA is considered the worldwide authority on oil production, and its estimates are used as the gospel truth, the agency may have failed in its duty to warn the world in a timely manner about the serious threat of peak oil. Under Monbiot’s intense questioning, Birol squirmed, and denied that the IEA had ever implied peak oil was not imminent, or that our current energy path was unsustainable. Revisionist history at its best!
Rather than redressing the agency’s past errors, Birol emphasized the urgency of its current outlook. "In this book, we are asking for a global energy revolution," he said, referring to the report. "The reason we are asking for a global energy revolution is to prepare everybody for a difficult days and difficult times." If the necessary $26 trillion investment in future energy supply and alternatives does not materialize, he warned, "we will have much more difficult days than we had [in the summer of 2008]…and there are also some other implications, for example there will be a huge transfer of wealth from consuming nations…to a very few number of countries, and of course this transfer of wealth may have many implications, in the energy sector and beyond."
Supply Outlook Worsening
The savants of Wall Street can talk oil down all they like, and the IEA can issue warning after warning, but if prices don’t recover soon, the energy industry is going to have serious problems maintaining supply.
As I reported in my column last week ("EIA’s Oil Outlook Report"), with oil in the low $40s, it has simply become unprofitable to sustain many energy projects around the world. And the list is still growing.
Expensive deepwater oil drilling projects off the coasts of Brazil and Africa are being delayed or renegotiated as the operators try to find ways to make the projects economically feasible. New refineries that were to be built in Saudi Arabia, Kuwait, and India have also been punted.
Marginal wells in the US, such as those in the shale plays, are being shut down. Brokerage firm Raymond James estimates that domestic drilling in the US could drop more than 40% next year.
Worse for the US is the fact that our number-one source of oil imports, Canada, is facing numerous cutbacks in its most expensive projects. Newer operators in the Canadian heavy oil fields and tar sands, who need prices above $90 a barrel, are sharply scaling back on their investments. The Norwegian oil company StatoilHydro recently backed out of a $12 billion project in Canada. In the last few weeks, Shell, Petro-Canada, and Nexen have all canceled or postponed new projects in Alberta.
A coal-to-liquids plant in South Africa was cancelled last week. Russian oil company TNK-BP slashed its 2009 capital budget by 25%. A major deepwater project in the Gulf of Mexico was suspended.
Even biofuel producers are having problems in lining up financing for their high-cost projects, delaying their much-anticipated additions to the total fuel supply.
A major issue facing fuel producers is that while their revenue has fallen along with oil prices, their costs have not. It will take awhile for today’s lower prices for steel and other materials to work their way through to energy projects, and even longer for labor prices to come down. To maintain profitability, producers must scale back on their capital expenditures and wait for their costs to fall, or their revenues to recover.
Meanwhile, with 12-month crude futures carrying a 10-year high premium over prompt delivery, it is more profitable to store oil and sell it at a later date than to deliver it now. Khelil believes that commercial inventories are now 400 million barrels above the average, with some 80 million barrels stored in oil tankers. However, the numbers being offered on the amount of oil in tanker storage right now have varied from 40 to 80 million barrels, and Bloomberg reported that oil companies have booked 25 supertankers for storage, with a combined capacity of 50 million barrels.
Oil Will Be Back – "With A Vengeance"
The slowdown in production has oil companies worried about what will happen when the global economy recovers. Royal Dutch Shell vice president Marvin Odum warned, "We’re in remission right now," he said, but when oil demand rebounds, "the energy challenge will come back with a vengeance."
I’ve been beating that drum for the last month myself (see "Oil Prices: Why the Past is Not Prologue"). While the outlook on oil prices may remain uncertain, there is no question that the stream of project cancellations and delays in the energy sector will put a significant dent in future supply. Eventually, we will hit an "air pocket" in the fuel line, and when we do, I expect a sharp rebound in oil prices.
Low oil prices pose another threat to oil and natural gas producers: it can reduce their reserves. Under securities regulations, they can only report reserves that are economical under a calculation based on oil and gas prices at the end of their fiscal year. Those who use the calendar year as their fiscal year may have to revise their reserves downward if oil finishes the year at current prices. Doing so would reduce the value of their reserves as collateral, and restrict their ability to raise capital for new and ongoing projects. Not only would it send a chill through investors, it would also spell further delays in future supply.
Unfortunately for the world, the oil trade does not do a very good job of discounting long-term considerations like marginal production cost, or supply constraints several years out. At best it responds to near-term estimates on global economic growth. It certainly isn’t discounting a peak of all liquid fuels within the next two years.
When these longer-term considerations do get priced in, oil will rise so fast, it will make your head spin.
At the ridiculously low valuations of some of the best names in energy, I think the time is ripe for a wave of mergers and acquisitions, as the top dogs seek to increase their market share-and their reserves numbers-to get positioned for the next bounce. The ones with the healthiest balance sheets and the most strategic reserves are now looking like easy triple-baggers when that time comes.
Until next time,
Chris
P.S. Although oil prices may not have bottomed yet, that doesn’t mean investors should sit back and be lazy. The problem is that the window for finding those up-and-coming energy stocks is running out. Many of your fellow Energy and Capital readers have already begun to prepare their portfolio for oil’s comeback. Perhaps it’s time you joined them. To find out more about the $20 Trillion Report, simply click here.
