A Difficult Start to a (Still) Turbulent Year for Global Oil and Gas

Some three weeks into the New Year, oil and gas markets, companies, and lenders are clearly off to a turbulent start, in many ways continuing trends we’ve witnessed for the last year. Since August of 2014 (see CSIS Energy and National Security Program commentaries on the topic), we’ve been consistently saying that resilient production, especially in the United States and Saudi Arabia/OPEC, a strong dollar, abundant and growing inventories, and the absence of significant new demand growth were likely to sustain low prices—certainly thru 2015 and well into this year. We continue to hold that view.

In recent weeks, oil prices have settled into the mid-high $20/barrel (bbl) range, the lowest in a dozen years and some 75 percent below levels reached in June of 2014. This despite a vast array of geopolitical risks, including terrorism and civil strife in Syria, Libya, and Iraq; turmoil in Venezuela and Nigeria; and deteriorating relations between Saudi Arabia and Iran. Risks are not disruptions, however, and the dominant narrative in the foreground is that abundant global stocks and ongoing competition between producers makes for supply growth that continues to outstrip demand.

North American production remains a focal point for energy analysts, not because of myopia or regional favoritism, but because, outside of the most prolific basins, tight oil producers are earning negative returns at current prices, even from “half-cycle” wells. Yet barrels keep flowing anyway as producers generate cash flows in hopes of surviving until prices turn, a classic prisoner’s dilemma, where individually rational decisions aggregate to holistic welfare loss.

In the near term, demand-side dynamics look like they could make things worse, not better. Refinery maintenance/turnaround season will only dampen demand for crude oil further and add to growing stocks. American drivers returned to the open road last year with surprising enthusiasm, but the engine of global consumption growth—non-OECD crude demand—remains stubbornly correlated to GDP growth. And in that context, the recent downward revisions by the World Bank and IMF and this week’s underwhelming (if expected) 6.9 percent growth number from China give us little reason to expect a sustained demand surge anytime soon.

Several difficult-to-judge supply catalysts remain precariously poised to contribute to market downside as well. As in recent years, the prospect of improved political stability (though often unrealized) in Libya and Iraq could result in production gains that exceed expectations by anywhere between 250 and 750 thousands of barrels/day (kbbl/d). This year includes a new unknown, too: the true scope and timing of Iranian volumes.

The end of oil and banking sanctions on Iran led to ambitious proclamations from Tehran that the Islamic Republic would substantially increase oil and gas production and bring additional barrels to the market sooner than originally anticipated. While Iran has clearly been preparing for the day when sanctions were lifted—by, among other things, pressure testing wells, valves, pipelines, and storage—it will nonetheless be hard to place large incremental volumes of crude in an oversupplied world, even with discounts. The International Energy Agency (IEA) expects 300 kbbl/d of Iranian crude to return within a quarter. Condensate exports from South Pars or floating storage can add to those liquid volumes.

The end of the ban on U.S. exports of crude oil and unprocessed condensate, by contrast, does not appear to present an imminent supply threat. While we applaud the lifting of the export ban as a matter of policy (the United States remains, after all, a free trade country), and recognize its value to serve as a long-term signal that encourages domestic investment by domestic producers, we would note that crude characteristics, quality, and price remain key determinants of refiner interest. Matching crudes to refinery equipment/configurations and desired product slates (to produce refined products that consumers demand) impacts refiner margins and their ongoing viability.

The Paris Agreement may have planted the seeds for binding, enforceable emissions cuts that cap global warming at two degrees Celsius, but transportation use of petroleum seems resilient in the absence of major battery storage breakthroughs due to crude oil’s energy density, stability, transportability, and versatility. It is, nonetheless, a warning to oil and gas producers down the road.

On the natural gas side, in no small part owing to the lack of an early cold winter, and continued prolific supply, Henry Hub prices are at 20-year lows for January (we write this, of course, as a blizzard bears down on Washington). An abundance of global gas plus weak demand has pushed Asian and European prices down as well. For now, anyway, the oil-linked gas prices in Europe may make Russian gas look more attractive!

On the regulatory front, the Environmental Protection Agency’s Clean Power Plan and methane rules, the Bureau of Land Management’s flaring rule for public lands, the Interior Department’s (Bureau of Safety and Environmental Enforcement) offshore drilling requirements, and the prospect of leasing restrictions are poised to put additional pressure on producers. Low prices insulate end-use sectors from economic impacts of new regulations (making regulation politically easier), but new rules take a bigger bite out of producers’ margins at low prices (making compliance more expensive).

On the financial front, even though the volume of opportunistic private capital on the sidelines remains significant, banks are poised to toughen loan requirements, a likely catalyst for increased asset sales and mergers in the year ahead. Bankruptcies dismantle companies, not molecules, and in the long run, viable, existing assets flow no matter who owns them. Investment is a different matter. Wood Mackenzie has estimated that in the current price environment, some $1.5 trillion in new energy investments are at risk, either with final investment decisions being delayed/deferred or higher-cost projects being cancelled outright. As experience has taught us: underinvestment today sets up a price spike tomorrow…although we mean “tomorrow” in the metaphorical sense of the word.

For the past year and a half, some market analysts have predicted that relief is just around the corner. Eventually that will be true, but for producers this has been—and continues to be—a very long and unpleasant block.

Frank Verrastro is senior vice president and holds the James R. Schlesinger Chair for Energy & Geopolitics at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Kevin Book is a senior associate, and Guy Caruso a senior adviser, with the CSIS Energy and National Security Program.

Commentary is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).

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