Chris Midgley, Chief Economist, Shell Trading
Thought Leadership – World Oil and Gas Week
31 October 2016
The oil industry is suffering from its deepest down turn and many commentators1 are now claiming crude may never recover to above $100/bbl. The industry is facing its longest down turn ever or, could it simply be an inflection point? So how have we got here and what have we learned so far? The rapid growth in production of U.S. light tight oil (LTO) in 2014 is often attributed with causing the decline, but in reality, sustained oil prices triggered over-investment across the industry – while also creating demand constraint as consumers were incentivised to be more efficient. Look at second hand car lots in the U.S. today and you will find them full of small cars purchased during a period of high oil prices that have been exchanged for large SUVs and pickup trucks, which now make up 80% of U.S. car sales2.
In November 2014, OPEC decided to no longer provide market support and to let the market decide for itself. While commentators accused OPEC of “flooding” the market, they in fact simply retained market share (in part helped by numerous producing countries suffering from supply disruptions). As a consequence, the industry saw $180bn of impairments in 2015 alone3, Capex slashed by $200bn (or 40%)4, 1,500 land rigs idled and 350,000 jobs lost5, net debt has increased6, credit ratings downgrades and US E&P bankruptcies have shot up7. During this period oil exporting countries have taken their fair share of the pain with Saudi drawing some $100bn of reserves per year, and outside OPEC, Russia and Brazil have suffered deep recessions. OPEC has truly tested the bottom of the market to show that it is unsustainable below $50/bbl.
OPEC have indicated that they intend to wrestle back control of this market8. Last September in Algiers, OPEC announced plans for production cuts that would bring forward the convergence of supply and demand and accelerate the drawdown of stocks. It is yet to be seen whether these cuts will materialise. However, a cut does not guarantee that oil prices will recover as fears still remain that U.S. producers will respond by swiftly increasing their production. In reality this is unlikely with the Saudis maintaining their assertion that they would like to manage oil prices within a price band. Cutting crude would enable oil prices to recover to more sustainable levels, while OPEC – Saudi Arabia in particular – would retain the option to be able to pump more oil if prices firm up too much, risking a return to demand destruction and upstream over investment. OPEC will have to settle for lower oil prices in the future if they want to sustain this model.
Continued low oil prices are good for demand. This gave an unexpected boost to refinery margins in 2015 as consumers increased demand for Jet, Gasoline and Light Ends for the production of Chemicals9. Refineries maximised runs that were further boosted by the liberalisation of Chinese Independent refineries to run crude increasing their yield of lighter products. The first ball of the “Newton Cradle” had been pulled again and it caused the system to be out of sync. Prior to this renaissance, refineries had focused on maximising distillates due to the impending commissioning of four “mega-refineries” coming on line in 2015, all with a distillates yield of over 60%. As refineries responded to the gasoline demand, distillates stocks increased, only to be compounded by weak Northern Hemisphere winter demand as we experienced mild El Nino weather. Gasoline cracks stayed strong and refineries stayed in maximum gasoline mode only to enter the summer with all stocks high, so margins collapsed.
The margin collapse surprised some commentators as refinery capacity declined during this period (if 1.1mbd of Chinese “teapot” rationalisation is included) while demand grew by over 1.5mbd. At the same time, Light Ends weakened and Fuel Oil cracks strengthened, despite China feeding crude to the teapots and Iran switching thermal power plants to gas. Refinery utilisation did increase, but this was achieved by using straight run fuel oil to load up surplus complex capacity, while the Light Ends demand was met by a significant increase in Natural Gas Liquids (NGLs) and Biofuels supply. Thus, significant growth in demand has been met by a much smaller call on refining. This situation can continue with growth of NGL supply. However, eventually, incremental residual fuel will need to be made from crude distillation to load up complex capacity.
As such, at a time when light crude supply is growing (US LTO, Libya, Nigeria return) and OPEC may be cutting heavier barrels, the pendulum could swing too far the other way leading to demand for heavy crudes versus light crudes. The IMO’s historic announcement to implement a global 0.5% sulphur cap in 2020 adds a new challenge, giving rise to fears of wide Gasoil-Fueloil differentials. Our industry will have to continue to be remarkably responsive to these major changes.
1Quote IEA http://www.bloomberg.com/news/articles/2015-03-03/l-shaped-oil-recovery-flattens-v-shaped-market-optimists
4 Barclays EP Spending Survey
5 http://www.ogfj.com/articles/2016/05/oil-and-gas-job-cuts-top-350-000-worldwide.html, Baker Hughs rig count &
6 Wood Mackenzie
9 Quote IEA http://www.reuters.com/article/us-iea-oil-idUSKBN0OR0UW20150611
About Chris Midgley
Chris Midgley is Chief Economist for Shell Trading and Head of Oil Markets Analysis. Chris advises the business on short term dynamics affecting Global Oil Markets as well as leading a team which model the future crude, oil products and chemicals trends. His team also provides supply and demand analysis and pricing models to support strategic planning and capital investment decisions across the Royal Dutch Shell Group.
About Shell Trading
Shell’s Trading and Supply business, through its network of global trading companies, is one of the largest energy trading operations in the world. We are active in most crude oil markets, sourcing from a wide range of suppliers and selling to a wide range of customers both within and outside Shell. As one of the world’s leading oil and gas companies, we have a deep understanding and expertise of what it takes to produce, transport and refine crude oil. Globally, we handle more than eight million barrels of physical crude per day.