I would like to share some thoughts on the possible oil price dynamics in 2014. To add a bit more credibility to this so that it does not sound as yet another ‘weather forecast’
Our base case has not changed – we remain constructive and see $100-110/bl Brent price as a realistic range which is high enough to motivate new investments needed to add more supply and is not too high for consumers to start cutting oil consumption across the board. However, relative stability of the oil (unprecedented compared to historic patterns) is the biggest concern for us. We see risks of higher oil price volatility this year which would increase the value of un-developed resources (by increasing their option value) and benefit holders of such assets at the expense of mature producers. This is one macro risk for our preference for second-tiers most of which are mature oil companies performing better in a stable or stably rising oil price environment.
Supply remains tight
As we pointed previously, base decline rate globally is around 5%, meaning the world oil production is losing about 4.5mb/d annually which needs to be replaced from new reserves.
Despite numerous projects being announced recently there are still few real additions to global supply. The most widely discussed US Shale revolution is projected to add about 3.5mb/d of new supply from now till 2016 – less than what the world needs to replace annually. Add to that the expected 1.2mb/d growth in demand in the next 2 years (according to IEA).
While the break-even price for most new production is in the $60-80/bl range – the price has to be actually higher to incentivise new investments and take extra risk. So it is really hard to see Brent go down below $100 over a sustained period of time.
It is also worth reminding that most of the growth over the past decade came from EM (of which BRICs contributed 64%), and it was almost entirely met by the FSU (mostly Russia) which added about 7mb/d. Most of this growth in supply was revival of old fields due to introduction of hydraulic fracturing and side tracks.
BRIC growth in demand and supply over the last decade (2000-2010)
Russia has peaked for now – we see less than 0.5% production growth this year and a likely decline next year as most greenfields are peaking and decline at legacy fields accelerates.
So the growth should be coming either at old countries restoring their production (Iraq, Iran, Nigeria to a certain degree), unconventionals (US for now) or new growth areas (Brazil, East Africa). Future production in the first group remains a political call but if history is any guide one can argue that betting on delays rather than positive surprise is a safer strategy. US has peaked in terms of incremental growth from unconventionals – it is likely that we will see just 1mb/d additional supply this year and declining to zero by 2016-2017 as shale production has c. 90% decline rates. New regions are important but not a big driver in the medium-term – we can see additional 5mb/d production by 2020 but this will not be enough to offset declines elsewhere and additional demand growth in the meantime.
Cost inflation is another major issue faced by mature producers – something we got a chance to see on the ground in Nov during our trip to West Siberia – the price of oil has to go up to keep new investments break-even.
Key risks and events to watch in 2014 and beyond
1. OPEC. For the first time in many years OPEC production will have fall below 30mb/d to accommodate rising non-OPEC volumes. This will inevitably raise tension between OPEC members especially two different camps of Venezuela and Iran, on the one hand, and Saudi Arabia on the other. Whether Saudi would re-visit its old tool to restore order by flooding the market with additional volumes as a way to punish likely cheaters remains a question. We doubt as Saudi does not have enough spare capacity compared to 1986, but that clearly remains the risk.
2. Iran. As a result of a multi-year sanctions Iran has lost almost 1mb/d with production bottoming out at 2.5mb/d during 2013 – the trend has already started to reverse with 2.7mb/d reported in November. Iran has agreed to cooperate with key nations on its nuclear development programme in Nov last year and thus set the stage for a significant easing of international sanctions against it, particularly those impacting oil exports. While the end of Iran oil sanctions would open a new chapter for oil markets, much work remains to be done by Iran and the P5+1 before reaching a full accord. Making room for Iran – assuming it could quickly ramp up production after years of sanctions – could be a challenge for other producers, especially in the face of rising non‐OPEC supplies. For now, though, other challenges loom larger.
3. Iraq. Contrary to the post-war trend of restoring production and improving internal politics the last few months saw renewed violence in the country. Production has not been affected significantly but one can argue this does not support further growth. Besides, we have seen a few majors withdrawing from Iraq to enter Kurdistan as the latter offers much more favourable fiscal terms even if infrastructure remains a question. The 1.7mb/d West Qurna-2 project – operated by Lukoil – is ready for a commercial start according to Lukoil and they expect first oil to flow in late 1Q14 – this will be an important milestone in the development of both – Iraq and Lukoil although we see risks of further delays given the ongoing violence.
4. LatAm. Brazil has been the biggest newsmaker in the second half of the past decades following offshore pre-salt discoveries and attracting dozens of international companies and capital – however recent regulatory changes and financial failure of the largest private player OGX changed the dynamics. It is likely that 5mb/d target set for this decade will likely be pushed back. At the same time, new countries in the region emerge as candidates for FDI to stimulate domestic production and attract foreign technology. Mexico announced a major overhaul to its terms allowing private companies to operate in the sector as an attempt to bring new investments into the country. Argentina seems keen as well although more on the gas side. All this is likely a multi-year process rather than a one-off event in 2014 but still important to watch.
5. Oil for gas substitution. This is again a mid-term process which represents a significant risk for the oil price. We have seen wider use of gas as a fuel for trucks in the US, Russia started considering this option last year. Transport consumes almost half of all oil production and even a slight substitution by gas could have a significant impact on the oil price.
6. Shale revolution outside of the USA. Many countries are looking to replicate US phenomenon. Various agencies provide estimates of hundreds of billions of oil resources locked in unconventional reservoirs outside the US – so this is definitely a big theme. However, industry conditions need to be there – particularly availability of rigs supply, other equipment, trained personnel, fiscal terms, land regulation and many others. Leaving geology aside – we think this is a long-term process and unlikely to change the dynamics in 2014, but again – watching this space is important.
7. New technologies. The success of Tesla is just one example of the potential of the technological progress to reduce consumption of oil in traditional forms. New sources of energy as well as all forms of energy saving technologies will continue to be tested in the future. Our view is that not only this will take time, but also it has a price – i.e. at $60-80 – the incentive to search for new technologies is much less than when oil shoots above $120. So having a stable and moderate range for the oil price ($100-110?) should serve the interests of producers more than aggressive price growth – something which Saudi Arabia has long understood.
So in summary – we do not see material factors for the oil price to stay outside of its recent range of $100-110 (for Brent) this year, although we point out that recent stability is quite unusual by historic standards and watching the space and be ready for more volatility should be prudent. Companies that offer structural growth and dividends are the best way to position one’s portfolio in such an environment (Bashneft, Tatneft and Surgut pref in our case). Also – OFS provides a great exposure to the structural theme of rising complexity of oil reserves.
Ildar Davletshin, CFA
Oil & Gas analyst
By: Ildar Davletshin