US shale will feel the heat of OPEC's price war

OPEC's battle with US shale producers for oil market dominance is already creating a sense of panic, with energy producers caught in the crossfire.

There’s a sense of panic now pervading the oil and gas sector as equity markets respond to the crash in oil prices. Whether it’s overdone or not will hinge on whether OPEC’s attempt to regain its dominant influence over the market for oil is successful.

It should be. While OPEC’s decision to maintain its production isn’t painless -- the Middle East producers are having to cash out their reserves to finance their budgets -- if the policy is sustained it should drive out higher cost production, bring the supply and demand for oil into better balance and see some level of firming in its price.

That’s the theory and the apparent strategy. Given that a lot of new oil and gas production was brought into the market in response to prices above $US100 a barrel, it would seem reasonable to assume that prices around $US50 a barrel will see a significant amount of supply predicated on much higher prices knocked out of the market.

The obvious target of the Saudi-led strategy is the US shale gas sector, which has helped increase US oil production by more than 50 per cent in the past five years, to around 9 million barrels a day, or nearly 10 per cent of global production.

While the timing of the impact of current prices on US production is uncertain, given that there is a lot of hedging activity around the sector that could delay the flow-through of the lower prices, the extreme depletion rates of shale reserves and the ability to quickly shut down unprofitable drilling probably means there could be quite a rapid response to the lower prices -- and an equally repaid resurgence in activity if the price were to rebound.

One suspects that the fate of the smaller end of the US shale sector, reliant on the junk bond market for funding (the energy sector accounts for about $US200 billion of the US high-yield debt market) may be determined by its financiers.

The US is seen, because of the nature and cost of shale oil exploitation, as something of a marginal or swing producer. The current oil price will determine whether or not that’s the case.

Russia, a relatively high-cost producer with a low-growth reserves base is already in turmoil and Brazil, Venezuela, Mexico, Nigeria, Iran and the Canadian oil sands producers are all going to be hit hard if the current pricing environment remains. Russia is a major source of global energy supply -- about 11 or 12 per cent of the global market -- so, as with the US, relatively modest losses of its volume could have a material impact.

At a corporate level, companies are already slashing planned investment and carving into current spending. There is a big supply-side response occurring already.

The surplus of supply over demand isn’t great. The International Energy Agency put demand for oil in 2014 at about 92.5 million barrels a day and supply at about 94 million barrels a day. Relatively small reductions in production would produce a balanced market even if there weren’t continuing growth in demand. (The IEA sees demand growing by about 900,000 barrels a day this year).

There are some wild cards that could complicate a stabilisation of the market and a shift to somewhat higher prices.

Libya, Iraq and Iran have massive low-cost reserves that, for obvious reasons, haven’t been producing at anything like their potential, although their production rates have been rising. If there were something remotely approaching stability in those countries there would be a structural change to the supply side of the market. One suspects that isn’t going to happen in the near term.

On the other hand, there will also be some pressure within OPEC itself -- which will increase as 2015 unfolds -- to cut back production to push prices up, given that most of the key OPEC members need higher prices to balance their budgets and sustain existing living standards and protect social and political stability.

For oil and gas companies, however, whatever the eventual outlook for the market and oil and gas prices they have to plan on the current prices being sustained for a significant period.

It is pretty obvious, for instance, that Woodside isn’t going to make any decision on the fate of the $US40bn Browse LNG project (recently deferred for a year) until the market stabilises.

Santos, the Australian producer most under pressure -- its share price has halved from its peak last year and is down about 40 per cent in the past six weeks -- has reduced its planned capital expenditures by about $700m to about $1.5bn less than in 2013-14 and organised a new $1bn debt facility. It also has about $2bn of cash and undrawn facilities and has a 13.5 per cent stake in the PNG LNG project that is now generating significant cash flows.

Origin Energy has extended the maturity of its debt, increased the limit on undrawn facilities and added to them.

Both Santos and Origin are nearing the completion of their $US20bn LNG projects in Queensland, which won’t start producing until the second half of this year.

While there has been some very hypothetical and ultimately meaningless discussion about the economics of those projects (and the value of Santos) if the current oil and gas prices were to be sustained in perpetuity, those are 20 to 30-year projects that Origin has said (of its own project) have cash break-even prices of around $US40 to $US45 a barrel of oil equivalent once fully operational.

The $US100-plus a barrel oil price last year may have generated some bubble-like valuations of oil and gas stocks and probably encouraged some bubble-time behaviours in sectors like US shale oil and gas.

The lower oil price environment will wipe out some higher cost and leveraged producers, discourage new investment in expanding supply and forced increased scrutiny of operating costs.

Given that underlying the current market settings is a global battle for market share and one that at current levels produces no winners among producers -- only lesser or greater losers -- however, it would seem rational that those settings can’t and won’t be sustained indefinitely.

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