The oil market tussle is far from over

OPEC's production stance has seen US producers slash capex and exploration spending, but the improving economics of shale extraction suggest the battle for dominance will endure.

In the past week the oil price has risen just over 20 per cent, raising the obvious question of whether the worst of the plunge in the price is behind us.

The short answer is that it is too early to tell. One theory is that, having heavily shorted the price as it plummeted from around US115 a barrel to below $US50 a barrel in the space of six months, hedge funds have now begun establishing long positions.

As with most commodities in the post-crisis period there is a lot of purely financial/speculative action in oil derivatives that impacts the market.

OPEC hasn’t changed its stance. It hasn’t cut back production to support the price; indeed it has slightly increased it. Inventories in the US still appear to be building, which would suggest that the fundamental factors that drove the price down are still present.

The collapse of the price has, however, had some real-world impacts.

If one of the targets of the Saudi-led decision to maintain production was the North American oil and gas sector -- and the US shale oil sector which has rapidly emerged as a threat to OPEC’s dominance of the market in particular -- it appears to be working.

In the 12 months to the end of January the number of rigs drilling in the US has fallen by 13.6 per cent and is now declining at a rate of about 100 a week. Canadian drilling activity is about 35 per cent lower than a year ago. BHP Billiton, of course, recently announced it would cut the number of onshore oil and gas rigs it has in operation from 26 to 16 (a near 40 per cent reduction) by June this year. It will, however, take some time before the full impact of the reduced drilling flows through to US production.

It isn’t just the youthful US shale oil sector that has been forced to respond to the implosion in the price. There has been a spate of announcements of cutbacks to capital and exploration spending by the big and established end of the oil and gas industry.

BG Group announced overnight that it planned to spend between $US6bn and $US7bn this year. It spent $US9.4bn in 2014 and $US11.2bn a year earlier. Earlier, BP said it would cut its capital expenditures by 20 per cent from a previously-planned $US24bn to $US26bn to $US20bn.

Shell has said it will lop $US15bn from its planned spending over the next two years; ConocoPhillips has followed up an earlier 20 per cent spending cut with a further 15 per cent -- $US5.3bn in total; Total will cut 10 per cent, or $US2bn to $US3bn from capex of around $US26 billion; Occidental will reduce its spending by a third, or about $US3bn; and China’s CNOOC plans to spend 35 per cent less, a cut to its capex of between about $US4.2 billion and $US5.8 billion.

So, tens of billions of dollars a year of investments in future production have been pulled out of the sector by those companies alone. Similar cuts to investment and exploration are occurring across the entire industry even as Shell has tabled plans to begin decommissioning rigs in its Brent fields in the North Sea that have operated for around four decades.

The cutbacks to future production of conventional oil will eventually have a very significant impact on the market and on the oil price. US onshore shale oil production can be turned on and off relatively quickly and cheaply -- US activity will be as sensitive to a rise in oil prices as it is now demonstrating (albeit with something of a lag) its sensitivity to their fall.

If OPEC wants to keep US onshore oil and gas out of the market, it will probably need to ensure the price is at or below the $US50 a barrel given that the economics of extracting shale oil have been continuously improving. The cost of drilling a new well fell 20 per cent last year as techniques continue to improve.

The other key factor that will shape the outlook for the price is, of course, demand. Oil prices above $US100 a barrel over the past four years and the weak state of the major economies have played a role in suppressing the rate of growth in demand. The sheer extent of the price decline and the slow improvement in the US economy, if sustained, could stimulate it.

There will be a point where the scale of the cutbacks in investment in future production, the depletion of existing producing resources and rising demand create stability and new price points for oil.

That moment is almost certainly not yet upon us but the breadth and depth of the response to the collapse in the price suggests that in the medium term the price is probably going to be meaningfully higher, rather than lower, and that the arm-wrestle for influence over it between OPEC and the unaligned producers, particularly the US, will be a continuing focus of discussion and tension within the sector.

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