Oil: The big drop ahead

Oil is getting cheaper … and expect the fall to accelerate.

Summary: Oil is on the slide, thanks to abundant and growing supplies. Demand for gas as an oil replacement in Asia is already starting to change the Australian energy equation.
Key take-out: For investors, an increased focus on liquefied natural gas presents better long-term opportunities over oil.
Key beneficiaries: General investors. Category: Commodities.

Oil prices are falling, not rising as forecast a few years ago. And if they do drop from their current $US100 a barrel to a forecast $US75/bbl, then it’s more than investment portfolios that will need adjusting because oil is a geopolitical tool that shakes nations.

The change in the outlook for oil can be seen in number of sectors, not least a dramatic “house-cleaning” by the world’s major oil producers which are reported to be trying to sell assets valued at more than $US300 billion ahead of the price fall.

As well as quitting non-core assets, the oil majors are in the middle of a major strategic shift. This is seeing them focus more on “upstream” operations such as exploration and production, and away from downstream operations such as refining and retailing.

The wholesale exodus from poorly-performing oilfields and refineries has already started in Australia with Shell selling its refining and service station business to Vitol, a Swiss-based commodities trader, and BP this week announcing the closure of its Brisbane refinery.

Cheaper oil, which runs directly against the once-popular Peak Oil theory of a world running out of oil, is being driven by a number factors including:

  • Major new discoveries in places such as in deep water off the coast of Brazil, across Africa and in North America.
  • The development of technologies to extract oil and gas once regarded as uncommercial, with the US shale-gas boom one example.
  • Slower demand growth as industry, especially the transport sector, becomes more efficient, and
  • The rise of natural gas as a globally traded and more environmentally acceptable liquid fuel which is benefitting from new extraction and liquefaction technologies.

Demand for gas as an oil replacement in Asia is already starting to change the Australian energy equation, causing problems as well as creating opportunities.

The obvious problem is that three new LNG projects in Queensland will utilise the east coast gas pipeline system to ensure they meet contractual obligations with Asian buyers if gas from coal seams being hurriedly developed fails to satisfy demand.

More gas going to Asia in the form of LNG is creating investment opportunities in Australia, as this week’s deal between the Kerry Stokes-led Seven group and the financially-stretched Nexus Energy demonstrates (see Why is Stokes on the gas train?).

The immediate outlook for Australia’s oil and gas sector will generate headlines next week when the industry’s top lobby group, the Australian Petroleum Production & Exploration Association (APPEA) holds its annual conference in Perth.

First item on the APPEA agenda, as it is every year, will be a report detailing how Australian oil production is declining.

However, what APPEA invariably ignores is that while Australia might be short of oil it does have world-class deposits of gas. This is why there are seven new LNG projects in various stages of construction around the coast, and why Australia might soon overtake Qatar as the world’s biggest LNG exporter (see Behold the new gas superpower).

While gas might pack less punch than oil as a source of energy it is proving to be more abundantly available than oil and steadily becoming easier to convert into a liquid (by chilling), increasingly accessible thanks to emerging technologies such as floating LNG production, and amenable to being traded like oil thanks to the development of more regasification terminals.

One of the people leading claim that the oil price is set to fall is Amy Jaffe, the US academic who correctly forecast that country’s shale-gas revolution four years ago (Another blow for gas projects). The way in which an energy-independent US would destabilise the global oil and gas sector by driving down the oil price is putting intense pressure on oil-producing countries such as Russia and Saudi Arabia.

In her latest comments, carried in Barron’s magazine, Jaffe argues that “barring a war that destroys physical installations for the production and transport of oil the oil price will fall precipitously over the medium term of three-to-five years”.

She particularly singles out Russia as a country facing severe financial problems, noting that the Russian government’s budget is expected to need an oil price of more than $US100 a barrel to stay balanced between now and the year 2020.

“A $US75 average would make the rouble’s recent tailspin look trivial in comparison.”

Jaffe is not alone in foreseeing a world awash in oil and gas. Edward Morse, head of global commodity research for the US investment bank, Citigroup, said a combination of flattening consumption and rising production made an average oil price of $US75/bbl “plausible”.

Morse added that: “The $US90/bbl floor on the world oil price over the past few years will become a $US90/bbl ceiling”.

Cheaper oil has the potential to dramatically change the way governments, industries and investors behave. Pressure already is emerging in the once-important biofuels industry where shortages of feedstock such as corn and wheat in the US has lifted the ethanol price above the oil price, crimping ethanol demand.

Other alternative and renewable energy projects, including high-cost wind and solar installations will also feel the pressure of cheaper oil and gas.

Oil itself will be under pressure from rising LNG production, which will appeal to governments keen to cut pollution levels, a possibility thanks to gas having better environmental credentials than oil or another energy source already under pressure, coal.

The changes underway in the global energy market lies behind the oil majors returning to their roots as exploration and production (E&P) companies rather than as refiners and retailers, partly because profit margins are higher in E&P and partly because new technologies are creating additional, but expensive exploration opportunities, which will require large amounts of capital.

New York-based Carlyle Group, one of the world’s leading private equity buy-out specialists, reckons that oil sector assets valued at more than $US300 billion are currently on sale.

Carlyle’s managing director, Marcel van Poecke, told the Bloomberg news service on Wednesday that: “It’s a buyer’s market. I’ve never seen a market where there are so many good assets for sale.”

Interestingly, what van Poecke sees as good assets are the same ones that the oil majors sees as surplus to their future requirement.

It is possible that both sides of the situation can extract value from the deals starting to emerge, but private investors should be wary of what might be offered by a private equity fund peddling a recently offloaded oil refinery or chain of service stations.

For Australia, the changes underway in its oil and gas industry include the closure of oil refineries which cannot compete with bigger and lower-cost Asian refineries and the rise of LNG as potentially the country’s biggest export earner.

Onshore LNG is the flavour of the month for the gas sector of the industry but the next LNG phase will be floating LNG (FLNG), with a fleet of massive new ships (called barges in the industry) under construction, or planned, including 14 in the US and six in Canada.

Australia’s first FLNG project, Shell’s Prelude development off WA’s Kimberley coast, is expected to be operating in the next few years with the hull of what is the world’s biggest ship nearing completion in Korea.

If it performs as promised Prelude will produce as much gas as a single onshore LNG “train”, around 3.6 million tonnes of LNG a year, and serve as a trail-blazer for a series of floating LNG projects.

For investors, the multiple changes underway in the oil and gas industry are both an opportunity and a challenge.

Kerry Stokes has found what appears to be a niche opportunity via the rescue of Nexus Energy. While other opportunities will pop up from time-to-time, the long-term trend of a falling oil price will cause problems for many companies.

Citigroup’s Morse is particularly cautious about the oil-price outlook, telling Barron’s that: “Modern civilisation would be impossible without cheap energy. I believe we are entering another period of cheaper energy that should last 50 years or more.”

Related Articles