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When The Dust Settles, The Oil Market Will Have Shifted, Perhaps Beyond Recognition

When The Dust Settles, The Oil Market Will Have Shifted, Perhaps Beyond Recognition
January 26
14:19 2016

Oilpro

Last week, Antoine Halff delivered one of the most enlightened commentaries on the oil markets we’ve seen during this downturn. Halff is currently the Director of the Global Oil Markets Research Program at the Center on Global Energy Policy, Columbia University. Previously, he served as the IEA’s Chief Oil Analyst, where he oversaw the Oil Market Report among other duties.

Halff articulates an informed summary of the current situation as few others can, and he provides perspective on the future that should not be ignored.

The full transcript of his remarks by way of the Center on Global Energy Policy, Columbia University follow. This is a 10-15 minute read but well worth the time.

January 19, 2016
Congressional Testimony of
Antoine Halff
Senior Research Scholar and Director of the Global Oil Market Program, Center on Global Energy Policy, Columbia University School of International and Public Affairs

Before the
Committee on Energy and Natural Resources
United States Senate
2nd Session, 114th Congress

Chairman Murkowski, Ranking Member Cantwell and Members of the Committee, thank you for inviting me here today to provide testimony on the global oil market outlook and the changes sweeping through the U.S. and international oil industry, not just in the United States but also globally.

Due to an array of market, economic, technological, policy-related and geopolitical forces, the oil industry is in the midst of a profound transformation. The interplay of these factors is a focus of the work undertaken by the Center on Global Energy Policy, an independent academic center at Columbia University’s School of International and Public Affairs, which I joined recently to launch a new research program on global oil markets. The analysis that I will present today is based on my work at the Center as well as research I conducted earlier as Head of the Oil Industry and Markets Division at the International Energy Agency. It is also shaped by my prior experience as Lead Industry Economist at the U.S. Energy Information Administration, head of Commodities Research at brokerage Newedge USA, Director of the Global Energy practice at Eurasia Group and Adjunct Professor of International and Public Affairs at Columbia University.

Last week, as I was preparing these remarks, futures prices of Brent and U.S. West Texas Intermediate, the main crude oil benchmarks, slipped below $30 per barrel, a 12-year low. That is a far cry from the highs of more than $100 per barrel averaged for the period from 2011 to mid-2014. Few had seen the crash coming; even fewer predicted its scope and duration. Eight years ago, when WTI markets rallied to an all-time high of $147/barrel, the prevailing narrative in oil markets was one of resource scarcity and runaway demand growth from China and other emerging economies. The specter of so-called ‘resource wars’ loomed large. Market participants were gripped by anxiety at the prospect of fierce international competition for dwindling resources. The idea that ‘the age of easy oil is over’ was the mantra of the day. The accepted wisdom was that prices have nowhere to go but up.

Since the beginning of the oil market selloff, roughly 18 months ago, early expectations of a rebound have been disappointed, and analysts have had repeatedly to push back their projections of a market recovery. Having failed to anticipate the price collapse and to predict its scope, market participants are now getting used to the idea that low oil prices have become the norm. “Lower for longer” is the new mantra. Automobile-industry executives, press reports tell us, are convinced that cheap oil is here to stay. At the time of writing, oil futures markets, admittedly a poor predictor of market conditions, were pricing crude oil for delivery in 2020 at less than $50 per barrel. For the oil industry, the fear of too little has been replaced by anxiety over too much. Faced with a revenue meltdown, companies have slashed their spending by a total estimated at nearly $400 billion. Tens of thousands of oil workers have been laid off, many of them in the United States. U.S. light oil imports, after a sustained period of decline, are rising again.

While it may be true that oil prices have yet to bottom out, expectations that cheap oil are the new norm are misguided. Predictions of long-term low oil prices will likely prove as wrong as the assumptions made just 18 months or two years ago of sustained, stubbornly high prices turned out to be. As in previous oil market cycles, a price correction is inevitable. Some of the very factors that have pushed prices down in the last 18 months will cause them to rebound in the next 18 months. And just as on the way down, the price swing upward may again surprise market participants by its speed, scope and duration.

Yet a rebound in prices, ineluctable as it may be, will not turn back the clock on the oil market. Nor will it mark a return to the status quo ante. The market that emerges from the current process of rebalancing will differ from the one that preceded it. The idea of a pendulum swing in oil markets is unexceptional; such swings have occurred in previous episodes of price correction. But this swing is different. When the dust settles, the market will have shifted, perhaps beyond recognition. The process of adjustment and restructuring ushered in by the price collapse marks the beginning of a new era in the history of oil and energy markets that will present both opportunities and daunting challenges for the industry.

What makes the current selloff and coming recovery different from previous market cycles is the advent of U.S. shale oil. The shale revolution has transformed oil market dynamics. It triggered the oil price collapse. It is now shaping the course of the recovery. It will eventually define the features of the energy landscape that will in due course emerge from the downturn.

Turning a glut into a bigger glut

The scope and duration of the selloff has defied expectations because of the surprising resilience of US shale oil production to remain high despite falling prices, but also because analysts had failed to anticipate that other producers would be incentivized to respond to a shale-induced supply glut by turning it into an even bigger glut. OPEC at its November 2014 meeting shocked the market by not cutting production in an attempt to balance the market and push prices higher. Since then, not only has the group refrained from reducing its output, but its two largest producers, Saudi Arabia and Iraq, have taken their production to new highs. So have other, non-OPEC, large producers like Russia and Brazil. This race to the top (or to the bottom in price terms) is a rational, predictable response to the new reality of shale production. But it is not sustainable.

Several factors account for the transformative impact of shale oil on supply dynamics. At roughly 4.5 million barrels per day today, U.S. shale oil makes up less than 5% of global oil supply. While that might not seem like much, just a few years U.S. shale production was zero. Shale oil alone accounts for the vast majority of the growth in non-OPEC oil production of the last few years. Advances in shale oil extraction technologies have caused ripple effects spanning the entire market and industry, both horizontally–throughout the oilproducing world–and vertically–across the supply chain. Shale oil in particular has led to a ‘regime change’ in oil pricing by forcing OPEC to throw away its playbook and put on hold the price-support policies that had defined it for the last 30 years.

Age of abundance?

There are at least three ways in which shale oil can be deemed revolutionary, each one of which has helped induce OPEC’s policy reversal. First, by unlocking vast resources that had long been deemed uneconomical, shale technology has upended the previous narrative of resource scarcity and dispelled ‘peak oil’ worries just as rising support for climate policies has cast doubt on the outlook for oil demand growth. This has raised speculation that large amounts of oil would have to ‘stay in the ground’ and fuelled concern about stranded assets, in turn changing the revenue-optimization formula for large, low-cost producers like Saudi Arabia. Shale has given Riyadh an incentive to speed up, rather than slow down, oil extraction.

In recent months, Saudi Oil Minister Ali al-Naimi has repeatedly evoked the prospect of what he called a ‘Black Swan,’ the risk that oil demand might fail to grow as forecast and leave vast amounts of oil unwanted – driven by technology improvements, more aggressive climate policy and structural changes in the economies of emerging markets. It is impossible to tell to what extent such concerns actually inform Saudi production strategy today. But the Kingdom has clearly messaged to the oil market that they were on its radar screen. Although seemingly long-term, these considerations have real, short-term policy implications.

A shrinking oil map

Another way in which shale oil changes the oil picture is by shrinking the global oil trade map. Surging U.S. shale production has curtailed the crude import needs not just of the United States but also of Europe. European refiners, faced with steep declines in domestic demand over the last decade, have struggled to compete with their cost-advantaged US counterparts, and have thus been importing less crude. Shale has accelerated the eastward migration of the crude oil market, the shift in its center of gravity to the so-called ‘East of Suez’ region. By 2020, Asia alone will account for no less than 65% of the crude oil market, according to projections from the International Energy Agency, up dramatically from levels as recently as 2014. That leaves crude oil exporters competing with each other in an increasingly concentrated Asian market itself dominated by supergiant Chinese oil trading companies with growing market power. In the past, OPEC oil exports were able to spread oil export cuts across their various export markets. Increased competition for Asian market share makes it extraordinarily hard for them to implement production cuts today, and even more difficult in the future.

A two-speed industry

Last but not least, the advent of the shale oil industry has been challenging the very business model of the oil industry. Oil companies have traditionally been large, deep-pocketed and professionally conservative, and have usually operated under a price umbrella of one kind or another: Rockefeller’s Standard Oil, the Seven Sisters, OPEC. Shale oil companies – small, nimble, highly leveraged, intensely adaptable – break that mold. Whereas conventional oil production requires large upfront investment and lead times measured in years if not decades, the shale business cycle is shorter: upfront shale costs are relatively low; decline rates are steep; lead times and payback times are measured in months rather than years. This shift to a two-speed industry – contrasting long-cycle conventional projects and short-cycle shale production – makes OPEC production cuts an impractical and inefficient way to support prices, as shale producers can swiftly respond to upward price movements by boosting investment and ramping up output in short order, thus defeating the purpose of the cuts. As long as shale production capacity is not durably degraded, any attempt by OPEC to retrench and lift prices runs the risk of effectively subsidizing shale producers and abandoning market share to them.  CLICK HERE TO READ THE REST OF THIS ARTICLE ON OILPRO

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