Oil price riddle yet to play out

Falling oil prices are showing no signs yet of bottoming out, with the impact of the slump threatening to spread.

The ever-deepening slump in the oil price has made forecasters look foolish time and time again over the past year and it is showing few signs of coming to an end. And as the ripples from its extended slide spread, it threatens to slow global economic growth even further.

More Business Videos

Explainer: What affects the oil price?

As oil prices continue to fall around the world, we take a closer look at global patterns of supply and demand.

Close followers of the oil price could be forgiven for feeling a little like Alice in Wonderland, who found it hard to make sense of the world after falling down the rabbit hole.

"It has flummoxed me over the past year," BT's chief economist Chris Caton says of the oil price slide.

The steep fall has prompted several global banks to cut oil price forecasts.
The steep fall has prompted several global banks to cut oil price forecasts. Photo: Simon Bosch

"Oil price falls of this order of magnitude are not uncommon, but are usually followed by a rebound. It is unprecedented for it to wallow for a year."

And don't expect much change anytime soon.

Advertisement

"I don't see any changes in a hurry. I don't see $US20 [$28.70] a barrel oil – I expect it could be around $US40-45 a barrel in 12 months time. It will stabilise soon – but remain very low for quite a long time."

Market drag

Kerry Stokes has stepped up his investment in oil in challenging circumstances.

Kerry Stokes has stepped up his investment in oil in challenging circumstances. Photo: Louie Douvis

The punishing drop has dragged on global markets through the opening weeks of 2016 and particularly lashed local energy stocks.

The share price of Origin Energy is down to levels not seen since mid-2013. For Santos, the dive is even deeper, its shares at their lowest level since 1993 – and, at $2.91 on Friday afternoon, a far cry from the $22-level touched in 2008.

Late in the week BHP took a heavy $US7.9 billion pre-tax write-down of its onshore US oil and gas assets as it cut drilling and prepared to slash spending as well, due to the "significantly weaker" than expected oil and gas price.

Similarly, the extended oil price dive makes the punt by other investors, such as Macquarie Bank and Kerry Stokes' Seven Group, on a rebound in oil prices look optimistic as the prospect for a return of the oil price back above $US100 a barrel for any sustained period over the next few years fades.

Stokes has bought up big in domestic oil producers Beach Oil and Drillsearch, which are now in a $1.2 billion merger that was triggered by the oil price dive, with Macquarie last year taking part in the $2.1 billion purchase of Apache Oil assets off WA.

A year ago, US investment bank Goldman Sachs forecast the oil price could fall to $US30, which many viewed at the time as an outlandish call – a level it touched this week. Last September, it followed that forecast up by tipping it could fall to as low as $US20 a barrel, although it expects oil will average around $US45 a barrel for 2016.

Many causes of carnage

For close followers of the oil market, there are a host of reasons for the extended slide. Notably, there was ''oil price shock'' that came from the decision in early December by the Organisation of Petroleum Exporting Countries (OPEC) to abandon any attempt to stem the slump in the oil price.

Then there is the removal of the embargo on Iran's oil exports, which is expected to see it lift exports from as early as next week, with a quick ramp up in exports by 500,000 barrels a day anticipated.

And, as with other commodity markets, the huge ''free kick'' to demand from surging Chinese economic growth is now fading, with energy demand falling below economic growth, a transition that has knocked energy markets for six.

China's slowdown is one reason for the weak global demand for oil, with the International Energy Agency putting global demand at around 1.3 million barrels a day in late 2015, well down from the highs of 2.2 million barrels a day seen a few months earlier.

Its next market update, which is to be released overnight on Friday, is not expected to point to any improvement in market fundamentals any time soon.

It reckons the price of oil could stay around $US50 a barrel well into the next decade, which is great news for motorists and large industrial users of oil such as petrochemical companies.

But it signals long-term pain for energy producers from BHP and Woodside through to Origin Energy and Santos, and will result in a wholesale reorganisation of the domestic exploration and production companies, with little improvement in job prospects as exploration spending is slashed.

Shale has reshaped the market

It will take time to absorb the supply overhang.

It will take time to absorb the supply overhang.

The change over the past few years has been the shale oil revolution in the US, which has seen it swing from an importer to an exporter thanks to the shale oil boom, but with concerns that the slump in the oil price could curtail a large part of its production as over-leveraged oil companies collapse.

More important to global demand growth for energy is China, where its thirst for energy is slowing, with economic growth now running ahead of growth in demand for energy, according to the IEA. At the same time, China's domestic gas production is forecast to grow at least five-fold over the coming decade, which will limit its demand for foreign supplies.

"China's transition to a more diversified and much less energy-intensive model for growth reshapes energy markets," the IEA said in a recent review.

The final piece of bad news came mid-week when the Energy Information Agency in the US forecast oil stocks will continue to rise until mid-2017, as global production continues to outpace demand, which drove the oil price to long-term lows below $US30.

"The first forecast draw on global oil inventories is expected in the third quarter of 2017, marking the end of 14 consecutive quarters of inventory builds," it warned.

"Crude oil prices are expected to remain low as supply continues to outpace demand in 2016."

And even once demand and supply moves into balance in late 2017, it will take time to absorb the supply overhang.

But since oil is priced in US dollars, the slide in the currency of many producer countries provides an automatic cushion. This is particularly the case for Russia, for example. Its currency, the rouble, has fallen to 75 roubles against the US dollar from 50 roubles over the past six months alone.

Even so, by late in the week, there was speculation Russia could cut some of its high-cost output in Siberia by around 5-6 per cent.

Investment banks slice predictions

The steep fall has prompted several global banks to cut oil price forecasts, with RBC warning its clients to prepare for steeper declines.

"Prices will likely head lower in the near term, with a trip through the 20s or lower possibly required to wipe the slate clean before fundamentals can fully return to the driver seat," it told clients.

RBC expects oil to average $US40 in the year ahead and rise to $US57 in 2017, but any uptick may not get under way until after the middle of the year.

The savaging of shares in energy companies in the wake of oil's dive has prompted fund managers to go shopping, with Warren Buffett topping up in oil independent Phillips 66, as Kerr Neilson's Platinum Capital bought into ENI, the Italian oil company, and Watermark Funds Management BP. But not everyone is convinced.

"We like to invest where the driver of our fortunes is under our control," said local fund manager Gabriel Radzyminski. "The oil price could go up or down; clearly I don't know. Buying in involves taking a directional risk – it's not just supply and demand at the moment but there is also a raft of geopolitical woes.

"It is hard to make much sense of what is going on."

Americans to keep on pumping

BT Financial Group economist Chris Caton isn't sure where markets are headed.

BT Financial Group economist Chris Caton isn't sure where markets are headed. Photo: Louie Douvis

US shale oil production may be costly, but many of its producers need to maintain output so they can maximise cashflows, which has caught out bargain hunting by fund managers among the distressed debt of US shale oil producers.

"A lot of distressed debt fund managers blew themselves up last year buying distressed debt of US shale funds, which continued to go down," Radzyminski said.

At some point some of the US high-cost producers will be forced to slash output, with forecasters estimating this could remove as much as 1 million barrels a day of US output in the coming months. Bankruptcies in the US oil and gas sector are rising but are yet to have much impact on output.

Even so, the basic laws of economics haven't applied to the oil market for some time now, BT's Caton warned, and that may not change.

"It is not just economics, but game theory" that is increasingly driving the market, he said. "The Saudis are quite happy to see US shale oil prices not make money, and also some other high-cost producers."

Economic impact unclear

The price of Brent oil futures has declined more than 50 per cent since its recent high of $US61.43 a barrel in early June.

The price of Brent oil futures has declined more than 50 per cent since its recent high of $US61.43 a barrel in early June.

Cheap oil typically triggers a rise in demand and, because it eases an effective ''tax'' on consumer consumption, should be good for global growth, but that fillip is not evident, economists said.

And there is a downside, since the fall is also further suppressing inflation at a time of heightened concerns over rising deflationary pressures, which may keep interest rates lower for longer than anticipated.

"Ordinarily the decline in the oil price keeps inflation low and therefore is good," BT's Caton said. "But we don't have much inflation at the moment, so low inflation is a negative.

"Interest rates are low and may not get back to historic norms for many many years," he said, with the low interest rate environment maybe persisting for another 5-10 years.

"You are seeing a few calamity specialists come out of the woodwork – but I'm not one of them, although we are going to be in this slough of despond for a period of time."

And just as the oil price shocks of the 1970s and 1980s forced wholesale changes to the global economy as heavy industry was forced to drastically reorganise, which eventually choked off much of the growth in oil demand, 30 years on, not only is industry far more energy efficient, but manufacturing itself is a smaller part of the economy, especially following the digital revolution.

Importantly, as it moves to focus more on services, China's demand for energy is rising more slowly than the expansion of its broader economy, with the focus now on India and how much its demand for energy will rise over the next decade.