Oil: Lower for longer

US unconventional production means it could be a long time before the oil price recovers.

Summary: Despite an uptick in the oil price this week, the current downturn is different as there is no guarantee US unconventional producers will be quickly forced out. It appears that OPEC has resorted to flooding the market with cheap oil without knowing what will happen to US shale output. Meanwhile, there is financial pressure on non-OPEC members such as Russia, which must keep producing to balance its budget.

Key take-out: US shale production will force OPEC – and investors in ASX-listed oil stocks – to live with a lower oil price for longer. It could be a very long time before the oil price returns to $US100 a barrel.

Key beneficiaries: General investors. Category: Oil and gas.

Welcome as the modest recovery in the oil price was earlier this week for investors in leading Australian stocks such as Woodside Petroleum, Oil Search and Beach Energy, the reality is that a long-term revival in oil is a long way off.

It would be going too far to say that the move back above $US60 a barrel was a “dead cat” bounce or relief rally triggered by Libya trimming exports, but that’s probably not a bad way to see any short-term rise in the price until the oil market moves back into a sustainable balance.

The only way that can be achieved is by a significant cut in global production, or a substantial rise in consumption, or both.

The problem with oil is that the current glut of petroleum liquids which has depressed the price is not a short-term affair, nor is it a conventional downturn of the sort seen several times over the past 40 years.

This is an unconventional downturn triggered by the rise of unconventional oil production from previously untapped sources of petroleum such as shale.

In previous periods of low oil prices, the problem was fixed relatively quickly with a reduction in production, especially by the cartel which has dominated oil since the 1970s, the Arab-led Organization of the Petroleum Exporting Countries.

What OPEC ordered in the past it largely got, despite a fair bit of cheating by cartel members.

At the risk of making a fool of myself this oil-price downturn really is different, for four critical reasons:

  • OPEC has forfeited a lot of its pricing power because many of its members have wasted decades of revenue on social welfare spending and will not survive a prolonged period of reduced output and low prices.

  • Only Saudi Arabia and the Gulf States appear strong enough to ride out the current cycle.

  • Russia, the world’s third-biggest oil producer, also cannot afford a prolonged period of low prices, or a cut in production.

  • There is no guarantee that the new kid on the block, US unconventional (shale) oil producers, will be quickly forced out of the game. Even if some are, the oil in the shale is not going to disappear if some wells are shut in for a while.

In effect, OPEC’s decision to maintain production as a mechanism to drive the oil price down and force high-cost rivals out of business (especially US shale producers) is a massive gamble which will cause pain to everyone exposed to oil.

But, unlike previous periods of low prices there is a new technology at work in a country which actually benefits more than any other from low oil prices.

What appears to be happening is that OPEC has resorted to a blunt instrument of flooding the market with cheap oil without really knowing what will happen to US shale output.

Some US production will undoubtedly disappear, but probably not for long because US shale oil, and the technology which has made it possible, is a modern-day equivalent of a genie escaping from a bottle, and once out it will be hard to put back.

The challenge for investors in oil stocks has not changed since it was explored here two weeks ago (see Oil plunge: What to do, December 3), which suggested that watching and waiting was the best way to treat the situation rather than panic selling.

Watching and waiting is still the best policy as shown in the ability of most ASX-listed oil stocks to broadly hold their ground since early December, with Santos the heaviest loser thanks to concern over its debt levels and speculation of a possible capital raising.

Other sector leaders appear to have settled into a “new normal”, perhaps because they have been reduced to the status of yield plays, which might be the best way to see the sector until the oil price does recover.

Woodside’s current dividend yield of 6.6% is certainly attractive, but whether that can be maintained in the long run is questionable.

What worries observers of the oil market is that the latest downturn in the price is more than a simple collapse in demand, or surge in supply. There are multiple problems, some of which have not previously been encountered.

Top of the problem list is concern that OPEC really is losing control of the market it regards as its private plaything.

But not far behind is the challenge of financial pressure on non-OPEC members such as Russia which must keep producing at a high rate to balance its budget, and then comes the “unconventional oil” challenge of the US.

Combined, the issues confronting oil are a poisonous cocktail which is precisely the opposite of what had been expected when Peak Oil theory was popular, an idea based on an assumption that global oil output had peaked and would enter a period of unstoppable decline.

Peak Oil theory has flown out the window, replaced by a totally different problem for oil producers and an unexpected bonus for oil consumers which, in a way, will be critical in creating the confidence which will consume the glut because oil usage is certain to rise the longer the price stays low.

Unfortunately, higher consumption rates will not be sufficient to drive the oil price back towards the OPEC target of $US100 a barrel. To get back there a lot of oil production needs to be turned off, and that’s going to be a case of who blinks first – and whether they keep blinking.

OPEC spokesmen have hinted that they’re prepared to see the oil price drift down to as low as $US40/bbl, if that’s what it takes to force a sizeable chunk of US shale oil out of the market.

The problem with that “conventional” approach to the current problem (flooding the market to kill rivals) is that the US is undergoing an “unconventional” oil and gas revival based on technologies of the sort the world has never seen before, and which are getting better and more efficient by the day.

It is possible that long before OPEC can succeed in killing the US shale industry it will have killed a number of its own members, and done severe damage to the Russian economy.

A key factor in US unconventional oil production from shale and other “tight” rocks is that it is based on drilling substantially more production wells than those found in a conventional oilfield, with each unconventional well being relatively shallow, quick and cheap to drill, with a short life expectancy.

Shutting down unconventional wells will also be a quick, cheap and easy option with the highest cost wells shut-in first as low-cost wells continue to meet local demand in an energy-hungry US.

A key factor in understanding what’s happening is that the infrastructure to tap US unconventional oilfields will not disappear overnight, nor will the oil in the ground.

Quite simply, unconventional oil and gas is a new industry which might be in its infancy but it is here to stay.

Even if OPEC succeeds in driving the oil price down to $US40/bbl, and forces the capping of thousands of US shale wells, those same wells will be switched back on as soon as the oil price rises to an acceptable level which is believed to be around $US75/bbl.

Boiled down, it could be a very long time before the world sees oil back at $US100/bbl – and every time it gets close to that production will respond, and the price will be capped.

US shale production is seen as the world’s marginal source of oil, but it is also the oil which will force OPEC to live with a lower price for longer – as it will investors in ASX-listed oil stocks.