Returning To Market Balance: How High Must Prices Be To Save The Oil Industry?

Guest Post by Art Berman

The global oil market is returning to balance based on the latest data from the EIA. That should mean higher oil prices but how high must prices be to save the industry?

Data suggests that oil producers need prices in the $70-80 range to survive. That is unlikely in the next year or so. Without more timely price relief, the future looks grim for an industry on life support.

EIA Revises Consumption Upward

Major EIA revisions to world oil consumption* data provide a new perspective on oil-market balance.

The world was over-supplied by only 570 kbpd of liquids in April compared to EIA’s earlier estimate for March of 1,450 kbpd; that March estimate has now been revised downward to 970 kbpd (Figure 1). February’s over-supply has been revised downward from 1,180 to 240 kbpd.

These revisions indicate that oil markets are much closer to balance than previously thought.

EIA adjusted world consumption growth for 2016 upward to 1.4 mmbpd. Its estimate for 2017 is now a very strong 1.54 mmbpd (Figure 2).

IEA’s demand growth estimate for 2015 is 1.8 mmbpd but the agency maintains its 1.2 mmbpd estimate for 2016 based on concerns about global economic growth.

It is easy to be skeptical about these new revelations but reports by both groups have been pointing toward improving market balance for some time.

Oil Prices and Market Balance

Oil markets are never in balance. Producers always misjudge demand and either over-shoot or under-shoot with supply. Balance is simply a zero-crossing from one state of disequilibrium to the next, from surplus to deficit and back again.

Since 2003, the oil market has only been within 0.25 mmbpd of balance 16% of the time. The average price (2016 dollars) for that near-market balance rate was $82 per barrel (Figure 3).

But that was essentially the average oil price of $78 per barrel for the entire period (Figure 4).

In fact, market balance occurred in every monthly average oil-price bin in Figure 5 except $130 per barrel.  Although prices above $90 per barrel represent 37% of near-market balance prices from 2003 to 2016, oil prices also averaged more than $90 per barrel 36% of the time during that 15-year period.

In other words, market balance merely reflects whatever price the market deems necessary to maintain supply at the time. There is no clear causal relationship between market balance and specific higher or lower oil prices. Balance merely represents the midpoint between prices on either side of the disequilibrium states that it demarcates.

Our recent memory is of $90-100 per barrel prices so we think that was normal. When those prices prevailed in 2007-2008 and in 2010-2014, the disequilibrium state of the market was largely deficit. Moving toward market balance and being on the deficit side of market balance are hardly the same thing.

The Price Producers Need

Lower-cost oil producers of the world (Kuwait through Deepwater in Figure 6) need $50-80 per barrel and an average price of $65 per barrel to break even. Probably $70-80 is a minimum price range for near-term survival of more efficient producers allowing that some will still lose money at those prices.

Existing Canadian oil sands projects, and Bakken and Eagle Ford Shale core areas are among the very lowest-cost major plays in the world. For all of the OPEC rhetoric about the high cost of unconventional oil, few OPEC countries are competitive with unconventional plays when OPEC fiscal budgetary costs are included.

Tight Oil Companies On Life Support

Despite this relatively favorable rating, most unconventional producers are on life support at current oil prices.

All of the tight oil-weighted companies that I follow had negative cash flow in the first quarter of 2016 except EP Energy and Occidental Petroleum (Figure 7). Nine companies increased their capex-to-cash flow ratios compared with full-year 2015 results and six increased that ratio by more than 2.5 times.

On average in 2016, companies spent $1.90 more in capex than they earned while in 2015, they spent $0.60 more than they earned. The percent of negative cash flow has increased more than three-fold so far in 2016 compared with 2015.

The good news is that about half of the companies (Apache, EOG, Laredo, Continental, Statoil, and Diamondback) only increased negative cash flow slightly despite falling revenues. The bad news is that the rest (Marathon, Whiting, Pioneer, Murphy, ConocoPhillips and Newfield) did not.

The debt side of first quarter earnings is far more disturbing. The average debt-to-cash flow ratio for tight oil companies increased more than 3-fold to 10, up from 3 in 2015 (Figure 8).

Debt-to-cash flow is a critical determinant of risk from a bank’s perspective because it measures how many years it would take to pay off debt if 100% of cash from operations were used for this purpose. This means that it would take these companies an average of 10 years to pay down their total debt using all cash from operating activities.

The energy industry average from 1992-2012 was 1.53 and 2.0 was a standard threshold for banks to call loans based on debt-covenant agreements. That threshold increased in recent years to about 4 but 10 years to pay off debt is clearly beyond reasonable bank exposure risk.

How High Might Oil Prices Go?

Current prices around $46 per barrel are a big improvement from earlier this year when prices were below $30. Nevertheless, all producers–companies and exporting countries alike–are failing and probably need sustained prices in the $70-80 per barrel range to survive.

That is a stretch from the mid-$40’s resistance level of the past 10 months or so (Figure 9).

Figure 9. NYMEX WTI futures prices and OVX oil-price volatility index, September 2014-2016. Sourc: EIA, CBOE & Labyrinth Consulting Services, Inc.

In fact, EIA’s forecast data suggest that improving market balance may result in a minor supply deficit by the second half of 2017 (Figure 10). Its forecast for Brent price, however, is to remain below $60 per barrel.

Through A Glass Darkly

The price rally that began in late January-early February 2016 seems to have substance even though there are outsized inventories that concern serious observers. Anticipation of future supply deficits are moving prices higher in defiance of present-moment fundamentals to the contrary. Recent consumption data from EIA support improving oil prices going forward.

At the same time, I expect to see high price volatility and price cycling similar to what has characterized oil markets since prices collapsed in late 2014. The current cycle appears to have found resistance at about $46-48 per barrel and will probably move downward in an uneven way over the next few months before beginning the next upward cycle.

Recent outages in Kuwait, Nigeria, Venezuela and Canada have underscored the fragility of supply despite the prevailing production surplus. Under-investment during 2015 and 2016 will undoubtedly lead to much higher oil prices in just a few years especially with strong demand growth.

Prices must eventually reach the $70 to $80 per barrel range to restore balance sheets enough that investment may resume. It is, however, difficult to see that happening in 2016 or 2017 without serious supply disruptions or an OPEC production cut. Otherwise, prices should gradually and irregularly improve over the course of several 4- to 5-month cycles.

The weak global economy will be an important check on price recovery. Demand has improved during the period of lowest real oil prices since the 1990s but I expect demand destruction at prices higher than about $60 per barrel.

The last two years have severely damaged the oil industry and some producers and plays will not survive even with higher prices.

A return to market balance does not necessarily mean that prices will return to the $70-80 range. That is the level necessary to keep enough producers in business to maintain an adequate supply of the world’s primary energy source at a somewhat affordable price.

If a weakened world economy cannot support those prices, we may see supply dwindle in a few years to levels that cause price spikes that cannot be absorbed. That may bring a traumatic end to the Age of Oil. People will have to learn to get by with less in a future based on lower energy-density fuels and lower economic growth potential than oil has provided.