Seven days that shook the world
Chairman, Chief Analyst and author of The Edge
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A black swan event. The coronavirus outbreak has derailed OPEC+, thrown the oil market into turmoil and sent an already unloved sector into freefall. What are the implications? Here are some initial thoughts from our research team.
Every week in The Edge, Wood Mackenzie's Chairman and Chief Analyst Simon Flowers shares his take on the natural resources industry's biggest stories, how they are likely to evolve and what that means for your business. Fill in the form on this page to receive a copy in your inbox every Thursday, four days before it goes public.
Will OPEC’s strategy work?
It will take time. The resilience of non-OPEC production has been a persistent irritation to OPEC since the last price collapse and may well remain so for some years yet. Led by US tight oil, non-OPEC producers have captured almost 100% of contestable demand growth since 2015, as OPEC’s market share has shrunk from 40% to 36%.
Hardly any non-OPEC production that’s onstream will be shut-in unless prices stay below US$30/bbl for an extended period. US L48 supply is likely to topple into decline in H2 2020 as investment falls away. But there’s material new supply growth on the way in the next two or three years from outside the US – projects in Norway, Guyana, Brazil and Canada. Russia is again a free agent to lift output. And, of course, demand growth is evaporating in 2020, and the structural implications beyond this year are unclear. If OPEC is determined to win back market share, it will have to keep prices low and be patient.
Can the industry live with prices under US$40/bbl?
Survive, perhaps, but thrive, no. Companies cut corporate cash flow breakevens from over US$90/bbl in 2014 to an average of US$53/bbl this year. Does management have the stomach – or scope – to do it again? Heavily indebted and high-cost producers may fail – the US L48 is particularly vulnerable.
For the survivors, there’s an opportunity to accelerate future-proofing for the energy transition. In upstream, that’s going beyond the inevitable cost cuts, reduced investment and, for most, lower shareholder distributions. E&P in the future has to run with fewer people, which will need a ramp-up in digitalisation – automation, robotics, artificial intelligence. Some reckon parts of an E&P business can run on less than half the present workforce. Now may be the time to start the ball rolling.
Can OPEC live with sub-US$40/bbl oil?
Not for long. Russia’s decision to quit OPEC+ for now reflects the relative resilience of its more diversified economy – the budget breaks even at around US$40/bbl Brent. It’s different for most OPEC countries. A number have low-cost, competitive production; but some have high-maintenance domestic economies funded in large part by oil revenue.
Saudi Arabia is one, and needs Brent over US$80/bbl to balance its budget. It has a substantial cushion of foreign reserves (US$500 billion end 2019) but during the last price war found these eroded alarmingly quickly, falling by one-third, or US$246 billion, between 2014 and 2017. Is the government prepared to burn more reserves this time to support a prolonged shot at squeezing out non-OPEC?
Will it all lead to higher prices?
Probably, but it’ll take time. The industry has done a great job in generating a lower cost hopper in the last five years, re-engineering projects, reducing costs and speeding up execution. But the service sector is on its knees in 2020 and the scope for underlying cost reductions is more limited this time around.
Non-OPEC investment is still below what’s needed for long-term renewal and will drop further in 2020. The reaction to lower prices will be almost instantaneous in the US L48, where less than 10% of tight oil resource breaks even below US$35/bbl (half-cycle, NPV15) and where corporate finances are most stretched.
The impact will come more slowly in conventional plays – investment will be held up by recently sanctioned projects that are already under development. But few new ones will get the go-ahead this year – a fraction of the 40 FIDs in 2019.
The world needs oil and gas for decades yet, and sustained investment in new supply. There just won’t be the capital available, or the risk appetite, for a while.
The price war could accelerate the new energy drive that was already gathering momentum. Low-return investment in new energy suddenly looks more attractive. The flip side is that there will be less cash available for the European Majors to fund diversification.
Another reason for capital markets to shun the sector?
Yes and no. Heightened geopolitical and commodity price risks add to ESG and energy transition concerns already weighing on the sector. This will harden the view of many investors that oil and gas is best avoided. Banks, too, are finding it increasingly hard to get board approval to lend.
But an oversold sector creates opportunities. A handful of IOCs and NOCs have access to capital and could seize the moment. The environment is also ripe for private equity. And US Independents may have no choice other than to consolidate if they are to survive this latest shock.