HOUSTON –
Forecasting the path of oil prices requires the powers of many philosophers, Zen masters and a little bit of James Bond. We are quite familiar with the philosophical question: "If a tree falls in a forest and no one is around to hear it, does it make a sound?" As Wikipedia explains, this is “a philosophical thought experiment that raises questions regarding observation and knowledge of reality.” Reality - that’s a great word today as we watch the crude oil market imploding. For those old enough to have experienced the 1986 oil price collapse, what happened last week was a flashback to early 1986. Between January 6 and March 31, 1986, crude oil spot prices fell from $26.53 to $10.25 a barrel.
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Another philosophical question we ponder is the traditional zen koan: "What is the sound of one hand clapping?" A koan is a question posed by a Zen master to a student and is meant to be pondered from within the routine of daily life until the answer opens the true heart of the question. As Answers.com puts it, “All koans must be answered from within the realm of one's own personal experience, and thus be encountered in the journey of living rather than in the rationalizations of logical thought.” Logic - another great word to be weighed when considering explaining today’s oil market gyrations.
Last we are left with James Bond – an iconoclast purveyor of martinis. His favorite drink order is a vodka martini that is shaken, not stirred – the wrong alcohol and the wrong mixology. In one scene in the movie Casino Royale, Mr. Bond is losing millions of dollars in a game of poker. He is obviously stressed and when asked if he wants his martini shaken or stirred, he barks, "Do I look like I give a damn?" Watching the oil market, one has the same reaction – just give me the alcohol!
So how do we use reality, logic and martinis to explain the current oil market? The martinis are probably more helpful than either of the words. Dulling our senses makes the pain more tolerable. The going ons in this market defy explanation. We were pondering comments about the health of and possible future direction for oil prices in light of the recent monthly publications of the International Energy Agency and the Organization of Petroleum Exporting Countries who offered sober outlooks. Numerous Wall Street energy analysts are busy revising their recently-revised oil price forecasts, but without any real conviction. And then there are the outlooks presented by two Texas-based economists who recently spoke at the MIT Enterprise Forum of Texas’ annual business outlook lunch.
In her presentation on the local economy, Kim Chase, Senior Economist with BBVA Research, part of BBVA Compass Bancshares, Inc., a unit of the BBVA Group (BBVA-NYSE), presented a forecast for WTI oil prices for 2016-2020. Her baseline case was bracketed with upside and downside cases. Ms. Chase’s slide had language to the effect that market conditions support a low oil price environment – no kidding! She described the market as characterized by the current oil oversupply, weaker than anticipated demand and the large overhang of oil inventories. When Ms. Chase’s slide first appeared on the screen, she immediately cautioned the audience not to react too violently to her 2016 baseline oil price number. Her number was viewed in the context of WTI futures prices trading that day between a low of $31.70 a barrel to $32.67 at the high. The futures price had opened trading that morning at $31.60, so optimism was in the minds of the audience. Of course, the MIT Forum was being held at the same time several Wall Street investment banks were offering their opinions that oil prices would have to fall to $20 a barrel, or possibly lower, in order to force operators to stop drilling, allowing production to fall and rebalance the oil market, leading eventually to higher oil prices.
While most of the audience was interested in Ms. Chase’s 2016 baseline oil price forecast, we were more intrigued with her downside forecast projecting a $19 a barrel average price. Given that oil was trading in the low $30s a barrel during the first two weeks of 2016, reaching a $19 average suggested a sharply lower price for a period of time and then only a modest price rebound as the year goes on. That scenario, we expect, would break the domestic industry, hurting the employment prospects from thousands and inflict significant economic harm on Houston.
Other interesting data points in her forecast were oil prices in the out-years, especially in the downside case. As shown in Exhibit 2, oil prices in that case peak at $21.50 a barrel in 2018 but then steadily decline until they are below $19 a barrel in 2020. Unfortunately, Ms. Chase did not discuss her thinking about the prices in the out-years, so we don’t know what set of events gets the industry potentially to a price in 2020 that is lower than in 2016. Our guess is that we would have a dismal economic backdrop and/or serious oil market share loss, most likely to increased efficiency, increased renewable fuels and/or low cost international oil producers.
Ms. Chase’s forecast is not the only low case we have seen in recent days. Oil price prognosticators are being forced to reconcile current low oil prices against their late-2015 forecasts, which did not expect prices to drop as much as they have. Doug Terreson, the oil analyst with Wall Street broker Evercore ISI, recently slashed his 2016 oil price forecast to $35 from his prior estimate of $65. The cut is predicated on slowing demand growth and increased supply. He pointed to two months of negative revisions to demand growth estimates plus the recent downward revision to global GDP growth projections by the International Monetary Fund to support his view. In addition, several countries have recently reduced fuel subsidies, sharply increasing the cost to operate vehicles in these countries that will impact petroleum demand. On the supply side, Mr. Terreson sees the increased tension between Saudi Arabia and Iran signifying an inability of OPEC to co-ordinate a reduction in the organization’s output. Furthermore, Saudi Arabian officials have said they will increase their output if world oil demand increases.
We continue to hear from consultants, oil industry executives and energy investors how the industry does not work at these very low oil prices. We understand all the analyses conducted showing how virtually every oil field and oil producer is losing money at current oil prices (high $20s to low $30s a barrel), but they continue to produce. Part of the reason they do is because they are worried about the long-term health of the reservoirs, noting that in the past, shutting down wells hurt their output when production resumed. That lost output can produce long-term damage to the health of companies. Continuing to produce, even at low oil prices, adds to a company’s cash flow, which may be important in keeping the lights on. As one small, private exploration and production company executive put it, he was happy that his company only had a small amount of production (that meant they had not drilled expensive wells during a period of falling oil prices), but on the other hand he was sad they only had a small amount of production as he could have used the extra cash flow to survive.
With oil prices dropping and E&P companies cutting their spending, the answer to our question of what is the sound of another shoe dropping is becoming clear. It is the sound of pink slips landing on employees’ desks. Living within one’s cash flow has taken on greater meaning for companies today. Unfortunately, the major operating costs are employees, especially when there isn’t much to do. Reducing costs to stay within cash flow means laying-off employees. Last Thursday afternoon, Houston and the oil patch were shocked by Southwestern Energy’s (SWN-NYSE) announcement that it was terminating 1,100 employees, or 44% of its labor force, as it deals with low oil and gas prices. The third largest natural gas producer indicated it had no drilling rigs operating and was reducing its capital spending plans for the year.
The next day, leading oilfield service provider Schlumberger Ltd. (SLB-NYSE) announced plans to reduce its workforce by 10,000 in response to low commodity prices and low oilfield activity. Since the third quarter of 2014, Schlumberger has cut 34,000 employees, representing 26% of its workforce. The company also stated in its fourth quarter earnings release that it doesn’t see an increase in oilfield activity until 2017. This view is rapidly being embraced by the industry and shaping all staffing and capital spending decisions.
Leading forecasting groups – the International Energy Agency, OPEC, IHS, Wood Mackenzie – are embracing the view that the current low oil prices will force the industry to further cut its activity during the first half of 2016 and that natural attrition in production will drop global oil supplies, despite the addition of possibly 300,000-500,000 barrels a day of oil exports from Iran this year. These groups also see demand continuing to grow, although uncertainty about the health of the Chinese economy is becoming a significant wildcard in the forecasts. On balance, these forecasters see the imbalance of global oil supply and demand, which has existed for the past two years, will return to a more balanced condition by the second half of 2016. A balanced market will allow bloated global petroleum inventories to start shrinking, which sets the stage for higher oil prices in the third and fourth quarters of 2016 and still higher prices in 2017. It will be the combination of continued oil demand growth, matched by a stable supply outlook and declining inventories, that drives an upturn in oilfield activity in the first half of 2017. The challenge for the energy industry will be getting back those employees receiving pink slips now.
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