We are nearly two years on from Saudi Arabia’s decision to cast off its traditional role as the central banker to the oil industry. That decision has led to a significant overproduction of oil and the collapse of the oil price from a high of $115 in June 2014 to below $30 a barrel last month. The oil price has recently bounced and is currently trading around $37 but there seems little chance of a significant near-term rise in the oil price. However, next year we could see a extreme rebound in oil prices as necessary investments in future oil production continue to be deferred.
Before that happens though the oil price needs to bottom out and find some stability. This should happen later this year as supply continues to fall in response to the low oil price. Until that happens Saudi Arabia and it closest allies the UAE and Kuwait are unlikely to reduce oil production. They want to see marginal producers out of the market and the only way that can happen is if oil prices continue to stay low.
The issue though is that the low oil price effects the whole industry who are cancelling and deferring CAPEX like never before. 2016, for instance, will be the first year in history that global oil CAPEX has fallen for two consecutive years noting that US oil-rig counts are at a five year low of 362 down from 802 a year. And the mood in the oil industry and among investors is extremely negative. We are seeing many leading upstream companies scrambling to sell assets to raise cash and we have already seen several smaller E&P companies file for bankruptcy with more to come. In addition, some 200,000 jobs have been slashed globally over the last 18 months.
This cut in global CAPEX (close to $400bn) increases the risk that we will at some point over the next 24 months not have enough oil, noting that there is not a lot of spare capacity among major producers such as Saudi Arabia, Russia, Nigeria and Iraq all of whom are pumping oil out at close to all-time highs. To make matters more difficult, it will be easy for a downsized industry in a capital constrained environment to respond quickly to any shortages. The investment cycles of oil and gas exploration are just too long with onshore at about 3 years and offshore at about 5 years.
The general view is that US shale will come to the rescue but the issue with this assumption is twofold; one the cost of capital for E&P producers has gone up significantly which will hinder their ability to respond to any shortfalls and even if the capital is available it will take 12 to 18 months to bring new oil on stream.
Next year existing oil wells are expected to produce 3m barrels less than this year and let’s assume a low 1.5% increase in global demand (1m barrels) which lead us needing to find an extra 4m barrels of oil every day next year. Where are those 4m barrels going to come from when CAPEX across the industry is being slashed? Of course, you hope that oil companies are investing in their existing wells to delay the onset of natural decline but the declines in existing production in places like Brazil, Britain, Russian, Canada and Brazil are so extreme that we need more wells and more oil finds. And that exploration and drilling is not happening. Hence my reasoning why we could very easily see a supply shock and a violent rise in the oil price over the coming 18-24 months.