21 Dec Those Crazy Guys at OPEC Are At It Again!
December rolls around and OPEC holds its semi-annual gabfest to argue out its oil market quota. They went into the meeting in a tizzy and came out in tatters. Are you wondering what happens to LNG now that the dessert plates have been cleared away and the limos have departed for the airport? Read on.
What Did OPEC Decide?
I feel a slight twinge of pity for oil ministers whose economies are fundamentally tied to the price of oil. They’ve had a good run for the past 7-8 years, watching the price of oil move steadily upwards to $110/bbl. Their treasuries bulged with foreign currencies, their sovereign wealth funds swelled to the size of sub Saharan Africa, and they bestowed upon their people magnificent wealth transfers. Just visit Dubai or Abu Dhabi and admire the money on display.
But the party is well and truly over. In a nutshell, OPEC decided to stay the course. And that course is to produce oil on an all out basis.
It’s only natural when the price of a commodity falls (and that includes sugar, coal, iron ore or oil) to produce more of it. That’s because revenue from selling undifferentiated commodities is a simple function of price times volume. As price falls, to maintain revenue, you ramp up volume. Sadly, this has the perverse effect of pushing down prices, which triggers more volume, and so on, until someone blinks.
You can watch this game of chicken play out in mining, where Anglo American, having ridden the coal price curve down until it simply hurt too much, decided that 60% of its mines, along with their combined workforce of 85,000, were uneconomic, and elected to shut them down or sell them off. Blink.
But OPEC isn’t the only oil producer. In fact, OPEC is only 30% or so of globally produced oil (other big players are Russia, the UK, the US, Norway and Canada). Those producers are also being entirely rational and are maximising volumes. Everyone is pursuing their own self interest. No blinking yet.
Lower for Longer
How long can this go on? Unfortunately, for quite some time, at least for the Gulf Arab States (Saudi Arabia, Abu Dhabi, Dubai, Kuwait, Qatar). These OPEC producers are not purely economic and rational entities since their governments own their oil companies. They can run their oil companies regardless of costs, devalue their own currencies, borrow money to prop them up, run down their sovereign wealth funds, transform their economies, restructure, and so on.
In my view, it’s going to be the other OPEC producers who will be the first to blink (Nigeria, Venezuela, Libya). They are far more dependent on cash flow from oil sales to meet their governmental operating needs, they have far slimmer sovereign funds to exploit (if any), and big wealth transfer obligations to their people. As their oil revenues fall, they will defer capital spending as long as possible, sowing the seeds for a future investment cycle.
The western free-marketers, including Canada, the US, UK and Norway, will shut in production when their economic models tell them to do so, which is when they risk destroying shareholder value at a pace in excess of what the falling oil price has already exacted. This is already underway – Canada has cancelled 15+ oil sands projects, the US has stacked up drill rigs, shale oil production has finally stopped growing, and the UK is contemplating shutting in and abandoning the North Sea.
No change in the direction of travel
For OPEC, the direction of travel is pretty clear. The Paris climate summit has reinforced the need to shift off carbon-based fuel sources. There’s been no let up in research into electric cars, batteries, solar power and wind. Big mining concerns are quietly jettisoning their coal mines. The US President finally said definitively that Canada’s oil sands bitumen would not get to the US via pipeline. Investment funds and universities continue to decarbon their portfolios. The US Attorney General has puckered up the courage to take Exxon to court over climate matters. It doesn’t matter what’s next, because we know it will be more of the same.
No change in the wild cards
The cowboy cards (unpredictable players who can impact markets) stayed in the deck. China has confirmed their commitment to cleaning up their air. Their economy is still soft, and they need to drive the shift to consumption and away from investment. Iran has maintained its dialogue with western oil companies to open up their markets. The draft of the TPP surfaced, with no mention of oil and gas as a protected species. The Russians haven’t invaded anyone else. In fact, Turkey’s shooting down of a Russian fighter plane did not cause any serious price movement.
What does this all mean for LNG?
Here’s my outlook for the LNG sector.
Anyone hoping for fresh LNG project approvals needs to revisit their calendars and reset their strategies. That includes suppliers hoping to supply, governments hoping for jobs and royalties, engineers hoping to do engineering, and workers hoping to work. I can’t see any approvals, except for regasification plants, going ahead for the next many months. With prices pushing below $40/bbl, the economics of LNG priced to oil simply fail. That includes the remaining proposed Australian projects, the Canadian projects and most of the US projects.
Delays to capital spend will drive further restructuring in the supply chain, including bankruptcies and mergers. There’s bound to be a few players (EPC firms, suppliers, gas plays) that are carrying high debt loads and facing serious cash flow shortfalls driven by the tail-off in project spend, revenue reductions as pricing hedges come off, and declining availability of capital. Capital portfolios are being put through the wringer and only the very best projects are going to get any support.
Brace for another round of impairments as capital markets weigh in and reprice all the underlying assets (and not just resources, but also kit and plant) to match the new low realised value. And the impairments will in turn trigger more belt tightening, more asset sell downs, more layoffs. If you’re an employee, now would be the time to be seen to be working on mission critical work.
The LNG projects still in flight, including those nearing completion or just into production, will be under yet more pressure to hack away at their costs. My research, admittedly not that scientific, suggests that while many supply costs are down 20% from their highest levels in Australia, services costs haven’t moved far enough. I would expect the industry in Australia, perhaps in the US and Canada, to finally reach enough of a crisis that all these conversations about collaboration and government cooperation take on fresh urgency and momentum to fix some of the industry’s deeply seated and costly behaviours.
Finally, gas buyers can no longer tell where the pricing bottom is. I thought it was $50, and now I’m not sure. And without bottom, there’s no incentive to sign onto the kinds of long contracts that LNG projects need to attract financing. Prices look like they could always go lower. Expect to see only a few new contracts, more gas contract renegotiations, and terms much more favourable to the buyer (FOB terms) than the seller (DES terms).
Yes, the oil markets have gone from swing to slow march, and so long as LNG prices link to oil, the LNG sector will continue to modify its dance to the oil tune.
Epilogue – I edited this post to remove a reference to the US oil export ban, now lifted.