Oil's drop is burning producers

Summary: Oil followers are tipping the price of oil will continue to fall as supply outpaces demand.

Key take-out: The biggest question in the oil picture is the long-term future of OPEC.

Too much oil, not enough demand. In simple terms that’s what is depressing the price of oil and the share prices of oil producers.

But the most concerning issue for investors is that today’s picture looks awfully like a re-run of the 2014 oil crash.

It won’t be a direct repeat for what happened almost five years ago because there are variations.

This time around there is the growth-sapping China vs US trade war, and the recent teaming of Russia with the Organisation of Petroleum Exporting Countries in a joint attempt to orchestrate a soft landing for oil, which has plunged by 27 per cent over the last two months.

But the primary problem for OPEC plus Russia is that they have no solution to the technology revolution that has unleashed a flood of oil from North America. This has restored the US as the world’s biggest oil producer, flipping it from being an oil importer into an oil exporter for the first time in more than 70 years.

Australia’s major oil companies will dodge the immediate effect of the fall in Brent-quality crude from $US83.52 a barrel as recently as October 5 to the latest price of $US56.84/bbl because they are heavily exposed to gas, which is generally sold under long-term contracts.

Over time, however, the lower oil price will feed into gas contracts, which is why all Australian oil stocks have seen their share prices fall.

As of Wednesday, Woodside, the sector leader, had dropped by around 21 per cent from $39 to $30.39 since that October 5 peak oil price. Santos was down 27 per cent to $5.31. Oil Search had fallen by more than 23 per cent to $6.86, and Beach had been hit hardest with a 35 per cent fall to $1.37.

The biggest issue on the demand side of the oil-price equation is the trade war, which has trimmed global growth and could get worse without a resolution.

But it’s on the supply where the real problem lies.

In what must be one of the financial world’s greatest ironies, the fear of an oil shortage, which galvanised markets in the 1970s and 80s, has morphed into a genuine and perhaps long-lasting oil surplus.

OPEC meets its match

Technology breakthroughs, such as finding ways to release oil trapped in tightly-packed rock, and exploration success in discovering big pools of oil in ever-deeper offshore waters, has ensured an abundant supply.

Without planning the outcome, what’s happening is that the US, which had been repeatedly held to ransom (along with the rest of the world) by OPEC, has all but killed the price-rigging cartel of mainly Arab oil states.

What’s worse for countries depending heavily on oil to fund their budgets is that the future looks largely like today. More than adequate oil supply is keeping one step ahead of demand, which is peaking as a switch to renewables and battery storage of energy gathers pace.

For OPEC and Russia, the next few years will be critical for their oil-dependent economies as they attempt to hold the oil price at around $US60/bbl, roughly where it is today.

But to do that, it is likely the more production cuts will be required because US oil production is surging.

What’s happening in oil is a classic clash between the free market and central planning, with the US championing unfettered oil production while OPEC and Russia try ways of manipulating supply and price.

Exactly the same thing occurred in 2014 when US oil output surged as producers in that country mastered the complexities of extracting oil from shale and OPEC responded by flooding the market in the belief that a depressed price would end the shale revolution.

Unfortunately for OPEC, the US shale industry not only survived, it got better in a tough environment, driving costs down faster than OPEC could depress the oil price.

Rather than kill US shale, OPEC almost killed itself.

A cloudy outlook for oil

This time around OPEC plus Russia is trying something different. Rather than flood the market, an attempt has been started to soak up the oil surplus by cutting production, initially by 1.2 million barrels a day in the hope that a floor price of $US60/bbl can be achieved.

The production cut might work, but that price target is not going to cause any problems for US shale producers who can make handsome profits at $US60/bbl. Since the 2014 oil flood they have slashed costs and discovered even bigger oil pools in places such as west Texas.

Conventional oil discoveries outside the reach of OPEC have also boosted production on the free-market side of the coin, such as a series of massive finds by a consortium led by Exxon Mobil off the coast of South America.

The next 12-to-24 months in the oil sector are loaded with uncertainty.

Ed Morse, the highly-credentialled oil specialist at Citi, a US investment bank, said in a research note released in New York this week that he expected oil to trade over the next few years in a range of $US45/bbl to $US60/bbl.

The lower end of his forecast is not that much higher than the $US38/bbl reached during the 2014 crash, though the oil industry does have the benefit this time around of lower costs.

The real problem for investors is the lack of long-term clarity in the oil market. While OPEC plus Russia might be able to maintain a price of $US60/bbl, there is also a chance that OPEC members will cheat, as they have in the past, and release excess oil to save their own economies.

UBS, an investment bank, has a more positive view of oil than Citi, with its long-term oil price forecast coming in at $US70/bbl. It sees a potential dip below that price as US production rises, thanks to the addition of new pipeline capacity to the red-hot west Texas shale sector.

“Despite changes to our outlook for oil prices over the next three years, we anchor our long-term view at $US70/bbl,” UBS said. “We believe it is the price required to incentivise investment in new supply to meet projected demand.”

There is obviously a wide gap between Citi’s $US45/bbl low water mark for oil and the UBS expectation of a $US70/bbl long-term price. It’s in the difference that risk lies for investors because the reality of oil is that no-one really knows which way it will go.

It is possible that OPEC’s price-rigging game is good for one last hurrah but because the cartel has faded to the point where it only produces one-third of the world’s oil, and its members are addicted to their oil-cash, they can’t afford to cut too deeply.

The US on the other hand, aided by other free-market producers such as Australia with its LNG and Qatar (which used to be an OPEC member) have learned to live with lower prices by cutting the costs to meet the market.

It’s a very brave observer to say that OPEC is doomed. But that might happen as the world’s least loved cartel goes the way of all other cartels and finally dies, leaving the oil and gas sector to market forces.