Conventional vs unconventional: Oil market grappling with two internal cycles

Another tumultuous volatility ridden fortnight has seen oil benchmarks go backwards and forwards, gaining and shedding couple of dollars, not just a few cents, on a near daily basis. We are firmly stuck in the $40-50 per barrel bracket for now and in this jumpy market every minor dataset triggers rapid fluctuations testing logical support and resistance levels, as traders attempt to find direction.

There is no doubting the third quarter of 2015 is likely to see the worst average quarterly Brent price since 2010, beating the first quarter’s average price by some distance (see below). Furthermore, plummeting oil prices will cause cash flow for the global integrated oil and gas industry to contract by 20% or more for 2015, with only a modest recovery expected in 2016, according to Moody’s. It reflects the ratings agency’s expectation of continued revenue declines and a negative free cash flow profile for the industry in 2015.

Quarterly Average Brent Price (Quarter to date 2015). Courtesy: HSBC

Overall, Moody’s outlook for the global integrated oil and gas industry will remain negative well into 2016. How low margin oil producers perform next year, as their existing hedging plans start rolling off, will go a long way towards deciding the direction of the market.

Of course, there are logical reasons to believe a supply correction is around the corner, but it would be painfully slow. The market correction this time around would be quite unlike anything the sector has had to contend with in recent memory, because there are in effect “two parallel cycles” in the oil market, according to a noted economist at Abu Dhabi’s oil revenue powered sovereign wealth fund.

Christof Ruhl, head of research at Abu Dhabi Investment Authority (ADIA), told delegates at the recent Gulf Intelligence Energy Markets Forum in Fujairah, United Arab Emirates, that the first cycle is the routine conventional oil story where the effects of ongoing capital expenditure cuts would only be felt 7 to 10 years from now.

“And then you have unconventional US shale where the response to ramping production up or down would be quicker and short-run focused.” Ruhl said the production pattern of shale oil is very different from conventional oil. “In a classic sense, it is not subject to a 7 to 10 year response [for better or worse] to investment increases or capital expenditure reduction that conventional oil plays remain susceptible to.”

The ADIA economist who joined the sovereign wealth fund from BP in May 2014, predicted in 2012 in his capacity as the oil major’s Chief Economist that the boom in US shale gas and unconventional oil would make North America almost totally self-sufficient in energy within 20 years, a theory that still rings true in turbulent times.

“That’s because shale oil supply is simply more elastic and responsive to prevalent market conditions, almost in a cyclical world of its own,” Ruhl opined. He also felt when oil prices started declining in the face of incremental supplies from July 2014 onwards, it was only rational for OPEC not to cut production in order to maintain its market share in strategic Asian markets. However, shale has shown tremendous resilience, and neither US nor Canadian production has suffered to the extent market forecasters thought it would because technology had been a great equalizer.

“Despite, the North American rig count falling, technological improvements have exceeded expectations to keep production steady if not in a state of constant increase,” he concluded. The dual cycle logic does ring true, and looks to be vexing OPEC. In one sense, its stance of maintaining production levels in order to maintain market share has paid off. However, conventional production is feeling the heat more, cutting more aggressively and can’t turn things around in the event of an uptick as quickly as plucky shale independents operating in Eagle Ford, Texas can.

Christof Ruhl, Head of Research at Abu Dhabi Investment Authority (center right) speaks to Sean Evers, Managing Partner of Gulf Intelligence at the Energy Markets Forum in Fujairah, UAE © GI,  17 September 2015

Ruhl said OPEC’s response from here is among the biggest uncertainties the market faces. “Nigeria, and Venezuela even more so, need the price to rise and would always vote for a headline production cut by OPEC members. However, paradoxically given their dire finances when times are desperate – in sheer economic terms they can do little more than pump as much oil as they can in order to monetize it.”

In theory, an extraordinary OPEC meeting can take place at three weeks’ notice or even less if the situation demands. However, having covered OPEC for nearly 10 years, I see few signs of there being one on the cards, despite mumblings from the likes of Venezuela in favor of one well before the scheduled summit in December.

Speaking at the same forum as Ruhl, Nawal Al Fezai, OPEC Governor for Kuwait, did little to raise hopes for an unscheduled summit. “All I can say is that in volatile times such as these, OPEC would be patient.” Al Fezai admitted OPEC depended on China to a great extent as one of its partners. “But, I think fears about a slump in Chinese oil demand are exaggerated, and I don’t see it falling to the extent that it did in Europe [or OECD markets] in wake of the 2008-09 global financial crisis.”

With China’s economy in transition, the riddle of Iraqi production, possibility of additional Iranian barrels coming on to the market, US shale rotating in it is own elastic cycle of ups and downs (should Ruhl be believed), are the known unknowns bound to complicate matters furthers in a market already struggling to find a floor.

Simply put, suffering or success of plucky US shale players is a tad different from the rest of industry and for better or worse won’t be on the same page as the ups and downs of conventional production. Shale might suffer but also has the capacity to bounce back sooner too.

http://www.forbes.com/sites/gauravsharma/2015/09/24/conventional-vs-unconventional-oil-market-grappling-with-two-internal-cycles/2/