Energy producers feel the pressure of an oil price plunge

A major structural change in the oil market has seen prices slump, with oil and gas producers around the world likely to endure significant pain in the near term.

Overnight the US Energy Information Administration reported that US crude oil and condensate production hit its highest levels since 1986 in August. Meanwhile, West Texas Intermediate crude prices are at their lowest level in four years.

It is no coincidence that a 60 per cent increase in US oil and condensate production in four years and production records being set in the major US shale oil and gas basins this year has finally had an impact on oil prices, which are down about 30 per cent from their peak mid-year.

The US Department of Energy’s latest assessment of US production puts it at around 9 million barrels a day -- its highest rate in more than three decades -- within sight of Saudi Arabia’s 9.6 million barrels a day.

The plunge in oil prices has Russia and the OPEC producers running scared, with Vladimir Putin saying last week that Russia was preparing for a "catastrophic" fall in prices and OPEC debating whether it needs to cut its production at its next meeting, scheduled for Vienna later this month.

The International Energy Agency last week referred to a "new chapter" in oil markets, predicting prices would fall further in the first half of next year.

While the steep decline in oil prices is good for consumers, as well as energy-intensive sectors like transport, manufacturing and construction, it is obviously not good news for energy producers. If sustained, it will obviously have major deleterious effects on the sector.

On the demand side, there are some obvious contributors to the tumbling prices. Japan (the third-largest oil consumer) is in recession, the eurozone is on the brink of another recession of its own, China’s growth rate has weakened and, while the US economy is growing, it is hardly roaring along.

The big structural change in the market, however, has been on the supply side where the US shale oil and gas revolution has fundamentally changed the market, as well as the politics of oil.

OPEC might well debate the merits of cutting production, its traditional response to weaker oil prices, but the rise and rise of the US industry has undermined OPEC’s ability to dictate prices, which might explain why the Saudis are signalling their reluctance to agree to significant production cuts..

It is worth noting that the sharp falls in prices have occurred despite the nasty civil wars in Libya, Syria and Iraq and the sanctions on Iran.

A recent Goldman Sachs analysis of the sector pointed to prices remaining low for the next several years.

If that is the case, the near-term impact on oil and gas producers will be material. LNG, of course, is sold on oil-linked prices and therefore sustained low oil prices are bad news for the LNG projects in and off Western Australia and the three big coal-seam-gas fed projects in Queensland that are now ramping up towards production.

Nor would it be good news for BHP Billiton, with its big petroleum operations that include a major onshore gas presence in the US. With iron ore, coal and oil prices falling in tandem and the Australian dollar holding at still relatively high levels, the traditional benefits of BHP’s diversity have, unusually, been undermined.

In the longer term, however, a period of sustained lower oil prices could help re-balance the market and eventually lead to stronger prices.

West Texas Intermediate crude prices are already at levels that would be hurting marginal US shale producers and beginning to deter new investment in dry gas provinces. Much of the US shale gas industry remains dominated by small and mid-sized companies and the capital-intensive and cash-burning nature of shale gas production makes them vulnerable to lower prices.

While big producers like BHP, operating in the liquids-rich Permian and Eagle Ford basins and experiencing rapidly rising productivity, would still be generating attractive margins, oil prices at or below $US75 a barrel for a sustained period (which is what Goldman has suggested) would inevitably have an impact on the rate of growth of US production by driving out the marginal production.

Sharply lower prices could also impact the economics and the capacity of US producers to export LNG if the explosive rate of growth in the US gas sector were to taper.

The US, obviously, wouldn’t be the only producing nation affected. OPEC members would be hard-hit, 'Big Oil' would have to cut back on new investment and what looked likely to be a global explosion of unconventional oil and gas developments leveraging the experience of the US industry might be curtailed before it gets properly underway.

That would, in the medium to longer term, be good for existing LNG producers and exacerbate what appears likely to be a significant shortfall of supply in the Asia Pacific region over the next decade.

In the near term, however, oil and gas companies are beginning to experience the same kinds of pressure and pain that has afflicted other commodity producers since China’s growth rate began slowing.