Commentary – The Unsustainable Oil Price
The definition of “unsustainable,” according to the Oxford Dictionary, is a situation which cannot be maintained at its current rate or level. Unsustainable is also the best way to characterize the oil price when it is near $US 30/B—a situation that is not tenable on many dimensions.
Many companies are losing money at $US 30/B. Here in Canada, where our local prices are even less once transportation costs and quality differences are factored in, oil sands producers are pumping out red ink with each barrel of bitumen they extract. Compared with oil sands, Canadian conventional and tight oil producers have lower operating costs and a higher valued product. However despite these advantages, many companies cannot keep the lights on at these prices. Even for the group that can generate some cash flow, the amount is a trickle compared to the past few years.
The pain is not isolated to Canada. In the United States, tight oil producers are also showing signs of distress. Reacting to low prices and compressed corporate cash flows, recently Continental Resources, Anadarko, Hess Corporation, and Noble Energy all slashed their 2016 spending plans in the range of 50% compared with last year. Further, Hess and Continental are also now predicting production declines for this year, demonstrating that even stubborn tight oil is not immune to $US 30/B oil. Supermajors are also under pressure. Chevron just released their first financial loss since 2002. In Brazil, Petrobras announced another round of cuts last week with the CEO describing the situation as “…a scenario of total distress.” And, while most Russian production is still generating positive cash flow, the country has marginal wells that are losing money at this point.
Oil and gas companies cannot lose money forever. We know trouble is brewing when the rate of money leaving corporate bank accounts is higher than the dollars coming in. Making matters worse, very few oil companies have savings to draw from. Assuming that price remains low for the next few months, the first quarter results will provide hard evidence of the level of financial pain inflicted by $US 30/B oil.
Today’s low price situation is also completely unsustainable for many governments in oil producing regions. As a domestic example, Canadian producing provinces – mainly BC, Alberta, Saskatchewan, and Newfoundland received $C 16.5 billion of royalty income in 2014, but last year, we estimate that the number was slashed to $C 7 billion. If prices hover around $US 30/B for most of 2016, this income will be squeezed to only $C 2 billion or about 10% of the 2014 level. This painful situation is not unique to Canada, it is challenging for all governments that depend on oil revenues to balance their budgets. It is no wonder why Nigeria and Azerbaijan are now looking for emergency financial help, or why Russia has recently become more interested in opening up a discussion on the possibility of an oil production cut.
Finally, today’s price is equally questionable when you consider the oil market fundamentals. When you adjust for inflation a $US 30/B oil price is near the price levels during the 1986 oil crash. Yet today’s oil market fundamentals are much stronger than 30 years ago, a fact that is not reflected in the current oil price. In 1986, spare capacity was equal to 12 MMB/d or 20% of global demand. With such a large glut of crude oil, lower for longer made a lot of sense back then—but not today.
Today, spare capacity plus the amount of crude oil that the world is overproducing equates to under 4 MMB/d or 4% of global demand. Even if Iran increases its production as anticipated, it is quite possible that declining production elsewhere paired with still-strong demand growth could balance the market within a year.
As the old saying goes, the best cure for low price is low price. All things the same, cheap oil will accelerate demand, cause more megaproject cancellations than there would have been otherwise, speed up the decline rates for neglected legacy oil fields, and inflict even deeper wounds in the oil field service sector. While it may not happen immediately, the pain of today’s unsustainably low prices will only strengthen the forces that will lead to tighter markets and a price recovery.